Product Market Advertising and Initial Public Offerings: Theory and Empirical Evidence

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1 Product Market Advertising and Initial Public Offerings: Theory and Empirical Evidence Current Version: May 2005 For helpful comments or discussions, we thank Sonia Falconieri, Gang Hu, Blake LeBaron, Holger Muller, Debarshi Nandy, Tom Noe, Imants Paeglis, Jay Ritter, Susan Shu, Narayanan Subramanian, and James Weston, as well as participants at the 2004 Financial Intermediation Research Society Conference at Capri, and seminar participants at Boston College, Brandeis University, and Tilburg University. We alone are responsible for any errors or omissions.

2 Product Market Advertising and Initial Public Offerings: Theory and Empirical Evidence Abstract We develop a theoretical model of the interaction between a firm s product market advertising and its corporate financing decisions. We consider a firm which faces asymmetric information in both the product and financial markets, and which needs to raise external financing to fund its growth opportunity (new project). Any product market advertising undertaken by the firm is visible to the financial market as well. We show that, in equilibrium, firms may use a combination of product market advertising, IPO underpricing, and underfinancing (raising a smaller amount of external capital than the full information optimum) to convey its true product quality and the intrinsic value of its projects to consumers and investors. Further, we characterize the conditions under which firms will use only advertising and underfinancing as signals, and those in which they will use a combination of IPO underpricing, advertising, and underfinancing. Our model has several predictions for IPO underpricing and product market advertising, two of which are as follows. First, firms will choose a higher level of product market advertising when they are planning to issue new equity or other information-sensitive securities, compared to situations where they have no immediate plans to do so. Second, product market advertising and IPO underpricing are substitutes for a firm going public. We present empirical evidence consistent with these two predictions of our model.

3 1 Introduction The role of the underpricing of initial public offerings (IPOs) in signaling firm insiders private information to the equity market has been extensively analyzed (see, e.g., Allen and Faulhaber (1989) or Welch (1989)). However, recently, some authors have questioned whether underpricing is the most efficient way to signal firm value, and have raised the possibility that it may be more efficient for firms to use other signals around new equity issues. For example, Ritter and Welch (2002) comment in their recent review of IPOs: On theoretical grounds, however, it is unclear why underpricing is a more efficient signal than, say,... advertising. Advertising is a particularly interesting signaling alternative to underpricing, since there is some anecdotal evidence that, in practice, some managers may indeed attempt to convey their firm s intrinsic value to the financial market making use of product market advertising (particularly in the context of an upcoming IPO). Consider, for example, the following quote from an article in the Wall Street Journal ( In Web Firms Ad Blitz, an Eye on Wall Street, August 19, 1999): As they plaster ads everywhere consumers might turn, companies are hoping to catch investors eyes too...businesses are often as interested in selling stock as in selling products; a high voltage advertising spree could serve as a critical prelude to an initial public offering. 1 Of course, whether these and similar anecdotes reflect the special situation, during a special time period, of only a few companies (e.g., internet firms going public during the bubble period), or whether they reflect the general situation of firms making equity issues, is an empirical question which has been unanswered so far in the literature. The objective of this paper is to explore, both theoretically and empirically, how the extent of product market advertising undertaken by a firm may affect (and be affected by) the prospect of its upcoming IPO. We develop our theoretical analysis in a setting where insiders of a private firm, with information about its intrinsic value superior to outsiders, raise external financingtofunditspositivenetpresentvalueproject. We address several related questions in the above setting. First, how will a firm choose the extent of its product market advertising in a setting where this advertising is visible to the financial market as well as the product market? Second, will the equilibrium level of advertising chosen by a firm be different in situations where 1 Another article, in the Boston Globe ( Internet Firms Bet on Super Bowl Ads to Reach Investors, Consumers, January 23, 2000), deals with television advertising during the Super Bowl. We quote: Hoping to impress Wall Street as well as fans, advertisers with names such as Pets.com, Lifeminders.com, and Ourbeginning.com will pony up at least $2.2 million for each 30 second slot on next Sunday s football game. Skip Pile, of Pile and Co., a Boston firm that helps companies hire ad agencies, offers the following appraisal: A Super Bowl ad can legitimize a brand among multiple constituencies: the company s employees, venture capitalists, the investment community, and lastly, the target audience of football fans. 1

4 the firm plans to make a public offering of new equity (either an IPO or a seasoned equity offering (SEO)) compared to a situation where it has no immediate plans to make such an offering of equity or other financial assets? 2 Third, of three alternative signals easily available to firm insiders, namely, underpricing, advertising, or underfinancing (raising a smaller amount of equity than the optimal in a full information setting), under what conditions will each signal be employed (either individually, or in combinations with the other signals)? 3 In particular, are advertising and underpricing substitutes for a firm in the context of its IPO? After addressing the above questions theoretically, we go on to provide some evidence regarding two of the implications of our theory. In particular, we empirically document how firms may alter the extent of their advertising in the context of an upcoming IPO, and how the extent of advertising relates to the extent of underpricing in the IPO. In our theoretical model, a private firm has an existing product, an ongoing project, and a growth opportunity (new project). Firm insiders have private information not only about the quality of the firm s products, but also about the true value of its projects: in other words, the firm faces asymmetric information in both the product and financial markets. While the firm has some internal capital available, this capital is not adequate to cover both the investment required in its ongoing project and to fund its growth opportunity. The firm therefore needs to raise external financing for investment by making an IPO. We assume that any product market advertising undertaken by the firm is visible to financial market investors as well. In the above setting, product market advertising can be thought of as playing two different roles. The first role played by advertising is that of signaling quality to the product market, thereby allowing consumers to price the firm s products correctly in equilibrium. 4 In our setting, however, product market advertising plays a second role: that of signaling the true value of a firm s projects to potential stock market investors, thus allowing them to price the firm s equity correctly in equilibrium. Since a firm s product quality and the value of its projects may not be perfectly correlated, an outsider (consumer or potential investor) who knows only thetruequalityofafirm s existing product cannot perfectly infer the true value of its projects; conversely, an 2 We will present much of our analysis in the context of a private firm raising external capital by making an IPO of equity. However, our analysis goes through with minor modifications for the case of a publicly traded firm making a seasoned issue of equity or other information-sensitive financial assets. Our model therefore has implications for these situations as well. 3 If a firm underfinances, it is forced to underinvest in its growth opportunity. Further, even though outsiders may not be able to directly observe the investment level chosen by a firm, they can infer its investment level by observing the amount of external capital raised by it. Thus, underfinancing and underinvestment are equivalent signals in our setting. 4 This product market role of advertising in our model is similar to the role played by advertising in the industrial organization literature, which has long argued that product market advertising plays an important role in conveying information about product quality to consumers (see, e.g., Nelson (1974), Kihlstrom and Riordan (1984), or Milgrom and Roberts (1986)). 2

5 outsider who knows only the true value of its projects cannot infer existing product quality perfectly. However, the firm need not use product market advertising alone as a signal, either to the product market or to the financial market: in a setting where the firm interacts with the equity market as well as the product market, it can also signal by underpricing equity in its IPO, or by underfinancing. In equilibrium, the firm uses the least-cost combination of the above three signals to convey its product quality as well as project value to outsiders. The equilibrium choice of signaling mix by the firm depends on the extent of asymmetric information facing the firm and the internal capital available to it. Consider first the case where the extent of asymmetric information facing the firm is relatively small. In this case, firms with superior quality products and higher intrinsic value projects (which we refer to as higher type firms) will use underfinancing alone as a signal, since, by itself, underfinancing is a less costly signal for the higher type firm to use than either advertising or underpricing. While underfinancing requires the higher type firm to scale back its investment in its growth opportunity, the cost of this underinvestment is partially offset by the reduced dilution in insiders equity holdings (which results from its raising a smaller amount of external financing). 5 Therefore, if the extent of underfinancing required to deter mimicking by lower type firms (those with either inferior products, lower intrinsic value projects, or both) is small enough that the higher type firm has to sacrifice investment only in the less productive range of its growth opportunity, then it can be shown that the firm will use only underfinancing as a signal. Consider now the case where the extent of asymmetric information facing the firm is more severe, so that, if the firm were to use only underfinancing as a signal, the reduction in investment required would be significant enough that the firm would have to sacrifice investment in the higher productivity range of its growth opportunity. In this case, the cost of signaling by underfinancing alone becomes prohibitive, and the higher type firm can lower its aggregate signaling cost by adding either advertising, underpricing, or both, to its signaling mix. The firm s choice between advertising and underpricing as the signal to add to underfinancing depends upon the internal capital available to it prior to the equity issue. In order to advertise, the higher type firm needs to cut back on investment in its ongoing project, thereby reducing firm value and diluting insiders equity holdings. If the internal capital available to the firm is large enough that only investment in the low productivity range 5 By dilution, we refer to the fact that when a firm sells equity at a lower price, insiders have to give up a greater share of the firm s equity to new investors in return for external financing. If the firm raises only a smaller amount of external financing, this dilution in insiders equity holdings will be smaller. 3

6 of the ongoing project has to be sacrificed to fund the required amount of advertising, then it can be shown that the firm will add only advertising to the signaling mix. If, however, the internal capital available to the firm is smaller, so that the firm has to sacrifice investment even in the high productivity range of its ongoing project, then minimizing the signaling cost involves the firm adding both advertising and IPO underpricing to the signaling mix, thus using all three signals to convey its true type to outsiders. 6 Our model has several implications for product market advertising in the context of equity issues, as well for IPO underpricing. First, our model predicts that firms will choose a higher level of product market advertising when they are planning to issue new equity compared to situations where they have no immediate plans to sell new equity or other information-sensitive securities. Second, it predicts that, in the context of an IPO, product market advertising and IPO underpricing are substitutes: the greater the extent of product market advertising, the lower the extent of underpricing. Further, the extent of advertising and underpricing undertaken by the firm depends upon how much internal capital is available to it prior to going public: as the firm is more financially constrained, it cuts back on the amount of advertising, while increasing the extent of underpricing. Third, it predicts that, when they plan to issue new equity or other information-sensitive securities, firms may advertise even in the absence of asymmetric information in the product market. Finally, our model implies that, in many situations, a combination of IPO underpricing and advertising (as well as underfinancing) may provide a lower cost signal to the product market compared to a situation where the firm is constrained (for some reason) to signal using advertising alone. In particular, it implies that firms which are financially constrained will signal to the product and financial markets using a combination of advertising and underpricing (as well as underfinancing). Our paper is the first in the literature to demonstrate theoretically how product market advertising can serve as a signal to the financial market in the context of new equity issues. It is also the first to study the interaction between product market advertising and underpricing in the context of IPOs, characterizing the 6 Therelativecostofunderfinancing, advertising, and underpricing as signals depends upon how expensive it is for the higher type firm to undertake each activity, relative to the cost to lower type firms undertaking the same activity to a similar extent (i.e., their cost of mimicking). When the extent of asymmetric information facing the firm is relatively small, underfinancing will be used alone as a signal, since the cost of a given extent of underfinancing is lower for a higher type firm compared to the same costforalowertypefirm which seeks to mimic it. In contrast, if a higher type firm funds advertising by cutting back only on investment in the low productivity range of its ongoing project, then the cost of advertising for the higher type firm will be similar in magnitude to the cost for a lower type firm which seeks to mimic it. Thus, advertising alone will be a costlier signal compared to underfinancing in our setting. Finally, for underpricing alone to serve as a signal, the higher type firm has to price equity in its IPO below the intrinsic value of the equity of the lower type firm (since, otherwise, the lower type would not incur any cost from mimicking). Given this, the cost to a higher type firm of diluting insiders equity holdings arising from underpricing will always be greater than the cost to a lower type firm which seeks to mimic the higher type firm. This means that underpricing alone will be a costlier signal than either underfinancing or advertising. 4

7 conditions under which various combinations of advertising and underpricing will be employed by firms to signal their private information in equilibrium. Thus, we provide insight into the ongoing debate in the IPO literature (mentioned earlier) regarding the efficiency of using underpricing as a signal. Our theoretical analysis demonstrates that it is indeed efficient for firms which are financially constrained to include both underpricing and advertising in their signaling mix. 7 Our paper makes an additional contribution by demonstrating how IPO underpricing can allow the firm to signal quality more effectively to the product market by reducing the amount of advertising required. We provide evidence consistent with two of the predictions of our model making use of advertising (and other product market) data as well as the financial market data of a sample of firms going public (IPOs). Consistent with the first implication of our model, we find that firms indeed increase their product market advertising intheyearoftheiriporelativetoabenchmarkyear(when they had no immediate plans to make an equity offering). Further, we find that, in the five year span around the IPO year (i.e., the IPO year, and the two years before and the two years after the IPO year), the peak advertising level is reached in the IPO year. 8 Second, we find that product market advertising and IPO underpricing are indeed substitutes: controlling for various other variables, we find that the extent of underpricing is smaller as the extent of product market advertising is greater. Our evidence indicates that managers do indeed take into account the effect of their product market advertising on investors in their firms equity when making their advertising and corporate financing decisions. This research is related to several strands in the theoretical corporate finance literature. Apart from the theoretical literature (discussed earlier) demonstrating the use of underpricing to signal insiders private information at the time of an IPO, this paper is perhaps most closely related to the theoretical literature on the interaction between the product and financial markets in the context of IPOs: see, e.g., Bhattacharya and Ritter (1983), who point out that one cost of going public arises from the need to release information in the firm s IPO prospectus (since this information may be used adversely by competitors in the product market); 7 The existing literature (e.g., Allen and Faulhaber (1989) and Welch (1989)) has demonstrated that underpricing can signal insiders private information about firm value to the financial market. In this literature, IPO underpricing works as a signal only because insiders price equity in the IPO in anticipation of a second round of financing subsequent to the IPO and the possibility of true firm value being revealed exogenously between the two rounds of financing. In contrast to the above literature, here IPO underpricing serves as a signal in the context of a one-shot equity offering. 8 This prediction of our model applies not only to initial public offerings, but also to seasoned equity offerings (SEOs). In regressions not reported in the paper, we also provide evidence consistent with this prediction in the context of SEOs. We find that the amount of product market advertising of a firm in the year of its SEO is greater than the advertising amount in a benchmark year two years prior to the SEO. The results from these regressions are available upon request. Note to the referee: While the SEO results are not to be published, we have attached them to the paper as a separate Appendix (Appendix B) for the purpose of refereeing. 5

8 and Maksimovic and Pichler (2001)), who study how the possibility of such an information release to product market competitors may affect the timing of a firm s going public decision. 9 Stoughton, Wong, and Zechner (2001) argue that the decision of a firm to go public may serve to signal high quality to the product market. 10 None of the above papers, however, address the role of product market advertising in IPOs (or in other equity issues); neither do they study how product market advertising interacts with underpricing in the context of IPOs. To the extent that we also empirically study underpricing in IPOs, our paper is also related to the large empirical literature on IPO underpricing (see Ritter and Welch (2002) for a review). The two empirical papers most closely related to ours, however, are Grullon, Kanatas, and Weston (2004) and Demers and Lewellen (2003). The former paper documents that firms with a greater level of product market advertising have a significantly larger number of both individual and institutional investors in their equity, lower bid-ask spreads (indicating a smaller amount of adverse selection in the market for these stocks), smaller price impacts, and greater market depth. In contrast to the above paper, which focuses on the behavior of stock market investors in response to increased product market advertising by a firm, our empirical analysis focuses on how firms choose their advertising levels in the context of a new equity issue. However, by demonstrating the role played by product market advertising in conveying firm insiders private information to equity market investors, our theoretical analysis is able to explain the reduction in adverse selection associated with a greater level product market advertising documented by Grullon, Kanatas, and Weston (2004). Demers and Lewellen (2003) document that, for a sample of internet firms, IPO underpricing is associated with a post-ipo increase in their website traffic. Unlike their paper, where the focus is on how internet firms IPOs affect their product market demand, our empirical analysis focuses on how the prospect of a firm s IPO affects its choice of advertising level, and how its choice of product market advertising level affects underpricing in its IPO. However, our theoretical analysis has implications for the empirical findings of Demers and Lewellen (2003) as well (see implication 5 in section 4). The rest of this paper is organized as follows. In section 2, we describe the essential features of our model, and in section 3, characterize its equilibria. In section 4, wedescribesomeofthetestablepredictionsofour 9 The broader theoretical literature on the going public decision (e.g., Chemmanur and Fulghieri (1999)), and the broader theoretical literature on IPO underpricing (e.g., Chemmanur (1993)) are also indirectly related to this paper. 10 Our paper is also indirectly related to the literature on product and financial market interactions outside the context of equity issues: see, e.g., Gertner, Gibbons, and Scharfstein (1988) analyze an informed firm s choice of financial structure when the financing contract is observed not only by the capital market but also by a competing firm. 6

9 model. In section 5, we provide evidence consistent with two of these predictions. We conclude in section 6. The proofs of all propositions are confined to the appendix. 2 The Model The model has four dates (time 0, 1, 2, and 3). Consider an entrepreneur owning a private firm, which has available to it an amount of internal capital W. At time 0, the firm has an existing positive net present value project which it plans to fund using (part of) this internal capital W. 11 The firm has an existing product, which it plans to sell in the product market in two rounds of sales, at time 1 and time 2, respectively. 12 A new positive net present value project (growth opportunity) becomes available to the firm at time 1. In order to fund this new project, the firm has the opportunity to go public at time 1. If it chooses to go public, outsiders come to know this decision right away. The firm chooses the price of the equity to be issued in the IPO, as well as the amount of the external capital C to be raised in the IPO, at this time. If the firm goes public at time 1, it invests the external capital raised, C, in addition to any amount left over from its internal capital W, in the new project. If, however, the firm does not go public at time 1, it invests only the left-over capital in the new project at time 1. At time 0, the firm chooses the amount of investment to be made in the existing project, as well as the amount of product market advertising to undertake, A. Weassumethatanyadvertisingthefirm undertakes in the product market is observable not only by consumers, but also by potential investors in the financial market. All cash flows to the firm are realized at time 3 including the cash flowsfromthetworoundsofsales of the firm s product and that from the firms investments in its two projects. We assume that all agents (entrepreneurs, consumers, and investors) are risk-neutral, and that the risk-free rate of return is zero. The sequence of events is depicted in figure Our assumption of an existing project merely serves to capture the notion that the firm has other ongoing business activities for which it also requires funding. In other words, the assumption of an existing project allows us to endogenize the fact that the firm has an opportunity cost of internal funding, with this opportunity cost increasing as the amount of internal financing available is smaller. All our results go through even in the absence of an existing project if we make the above assumption about the opportunity cost of the firm s internal financing exogenously. 12 We assume that issuing equity is the only source of external financing, so that firms cannot fund their projects by issuing debt or other financial assets. 7

10 Firm determines the amount of advertising to be undertaken. Firm invests in the existing project, using its internal capital. Interim signal of product quality is received. Second round of sales of the firm s product. t = Firm goes public in the stock market: it determines the amount of capital raised and the pricing of equity in the IPO. Firm implements its investment in the new project using the external capital raised from the IPO and the internal capital left over from time 0. First round of sales of the firm s product. All cash flows are realized including the cash flows from the two rounds of sales of the firm s product, and that from the firm s investments in its two projects. All asymmetric information in the product and financial markets is resolved. Figure 1: Sequence of Events 2.1 Information Structure in the Product and Financial Markets Both the product and financial markets are characterized by asymmetric information. In particular, we assume that there are products of two quality levels in the product market: Superior (S) andpoor(p ), with the quality of superior products being higher than that of poor products. We also assume that there are two kinds of projects: Good (G) andbad(b). For any given level of investment, good projects yield higher cash flows than bad projects (i.e., the NPV of good projects is greater than that of bad projects at any given investment level). While firm insiders know the true quality of the firm s product as well as the net present value of its projects, outsiders (be they consumers in the product market or investors in the financial market) observe only the prior probability distributions over product and project types. In order to capture the above asymmetric information in the simplest possible manner, we assume that there are three types of firms: H (high), M (medium), or L (low). We denote firm type by k, k {H, M, L}. We assume that a type H firmalwayshassuperiorqualityproductsaswellasgoodprojects;atypemfirm has poor quality products but good projects; a type L firm has poor quality products and bad projects. 13 Figure 2 summarizes our definition of firm type as a function of product quality and project value. While firm insiders observe the type of their own firm, outsiders observe only the prior probability distribution 13 Thus, we assume here that the product quality and project value are correlated, but not perfectly so. Clearly, assuming that both product quality and project value are perfectly correlated is somewhat less interesting, since, in that case, if product quality is revealed, project value is completely known as well. Note that our results are not driven by the correlation between product quality and project value. At the expense of some additional modeling complexity, it can be shown (using a four type model) that our results hold even when product quality and project value are completely uncorrelated. 8

11 Firm Type (k) High (H) Medium (M) Low (L) Product Quality Superior (S) Poor (P) Poor (P) Project Value Good (G) Good (G) Bad (B) Figure 2: Firm Types across firm types at time 0: outsiders believe that the firm is of type H with probability γ 1 ;oftypemwith probability γ 2 ; and of type L with probability γ 3 ; γ 1 + γ 2 + γ 3 = 1. At time 3, all cash flows are realized so that the asymmetric information between firm insiders and outsiders is resolved completely. 2.2 The Firm s Product and the Product Market We assume that, in the absence of asymmetric information, consumers value superior quality products at R S, and poor quality products at R P, R S >R P. We assume that the demand for the firm s products is perfectly elastic, so that, in a full information setting, R S and R P will be the prices prevailing in the product market for superior and poor quality products, respectively. Each kind of product will be sold in the product market for two rounds, i.e., at time 1 and time 2. Between time 1 and time 2, i.e., after the first round of sales of the firm s product but before the second round, a signal of product quality becomes publicly available. We can think of this signal as a (probabilistic) breakdown of the firm s product. We assume that the probability of breakdown is α for a poor quality product and 0 for a superior quality product, with 0 < α < The production capacity of the firm is Q units, which is not variable. The production costs for the superior and poor quality products are assumed to be the same, and normalized to zero for analytical simplicity. We assume that quality is not a choice variable for the firm: i.e., each firm is endowed with technology which allows it to manufacture products only of a given quality. 2.3 The Firm s Projects and the Financial Market For simplicity, we assume that the investment technology for firms with both good and bad projects is piecewise linear, as depicted in Figure 2. Thus, for good projects, the productivity of investment is g when the investment 0 <I i 1 ;itisb, 1<b<g,wheni 1 <I i 2,and1forI>i 2. For bad projects, we assume the 14 Thus, in the case of pooling in the product market at time 1, customers update their prior at time 2 based on the signal of product quality occurring between time 1 and time 2. In particular, at time 2, a product is believed to be of superior quality with γ a probability 1 (1 γ and poor quality with a probability 1 )(1 α) in the absence of a breakdown of the product. γ 1 +(1 γ 1 )(1 α) γ 1 +(1 γ 1 )(1 α) 9

12 NPV NPV of marginal investment: b-1 NPV of marginal investment: 0 Good Projects NPV of marginal investment: g-1 NPV of marginal investment: b-1 NPV of marginal investment: 0 Bad Projects i 1 i 2 Amount of Investment Figure 3: Investment Technologies for Good (G) and Bad (B) Projects productivity is b if 0 <I i 2,and1forI>i 2.Wecanthinkofi 1 as the high productivity threshold level of investment; i 2 as the full-investment level (in the sense that for either kind of project, if the investment made is below i 2, then NPV is wasted). We assume that these investment technologies are common knowledge. We also assume that g b > R S R P, implying that the ratio of the intrinsic values of good and bad projects is greater than the ratio of full-information prices of superior and poor quality products. As discussed before, the firm has two projects: an existing project initiated at time 0 when the firm is private (and funded with only internal capital), and a new project which becomes available at time 1 (which may be funded with money raised in the financial market if the firm goes public at time 1). Both projects of any given firm are of the same type. 15 We assume that the internal capital owned by each firm before going public, W i 2,sothatanyfirm can finance at most only one project (either the existing or the new project) to its full investment level by using internal capital. Thus, if the firm wishes to fund both its existing and its new project to the full investment level, it has to go public at time 1. In this case, the firm will fund its new project partially or fully using the external capital raised from its IPO, depending on whether there are any funds from its internal capital W left over after investing in the existing project. Thus, the magnitude of the internal capital W is a measure of the degree of the financial constraint faced by the firm prior to its IPO. Throughout this paper, we assume that the productivities of both types of projects, i.e., g and b, are large enough that all firms will choose to go public to raise capital for investment in their new projects even after accounting for the 15 This assumption is made only for convenience. Our results are driven only by asymmetric information about the new project, and will therefore be qualitatively unchanged in the absence of asymmetric information about the firm s existing project. 10

13 cost associated with doing so (i.e., the dilution of firm insiders equity). 2.4 The Firm s Objective The firm s objective is to maximize the expected long-term (time 3) value of equity held by the entrepreneur (or equivalently, the present value of expected total cash flows to the entrepreneur). The firm s revenue arises from two sources: the two-rounds of sales of its product, and the revenue stream from investment in its existing project (at time 0) and in its new project (at time 1). Thus, the entrepreneur strategically chooses the firm s expenditure on advertising, the amount of external capital raised by going public, the amount of investment in its projects, and the price of equity in the firm s IPO, to maximize this objective. 3 Equilibrium Equilibrium strategies and beliefs in our model are defined as those constituting a Perfect Bayesian Equilibrium (PBE) satisfying the Cho-Kreps intuitive criterion, and which minimizes the dissipative costs of separation incurred. 16 In other words, the equilibrium concept we use is that of a Pareto dominant or efficient Perfect Bayesian Equilibrium which survives the Cho-Kreps intuitive criterion. 17 We will focus only on separating equilibria, where the three types of firms fully reveal their types to both the financial and the product markets in equilibrium. 18 Before going on to characterize the equilibria of our model, we analyze the problem faced by each type of firm. 3.1 Analysis of the Firm s Problem We now analyze the trade-offs faced by the three types of firms in arriving at their equilibrium strategies. In particular, we analyze how each firm arrives at its equilibrium choice of signals. In our discussion below, we will focus primarily on the type H and type M firms (and not on the type L firm), since, given the equilibrium choices made by the type H and M firms,thetypelisalwaysworseoff mimicking the above firm types compared to its payoff if it follows its full information equilibrium strategy. 16 See Fudenberg and Tirole (1991) for a formal definition of a PBE and Cho and Kreps (1987) for a definition of the Cho-Kreps intuitive criterion. 17 See Milgrom and Roberts (1986) or Engers (1987) for a detailed discussion of why the notion of a Pareto dominant or efficient PBE is the appropriate equilibrium concept here. 18 Given that two dimensions of asymmetric information exist in our model, one can also think of a variety of pooling equilibria satisfying PBE, involving either pooling in the financial market, or in the product market, or in both markets. However, most of these equilibria do not satisfy the Cho-Kreps intuitive criterion, and thus do not satisfy our equilibrium definition. The focus of the analysis in this paper will therefore only be on separating equilibria. 11

14 3.1.1 The Type H Firm s Problem TheobjectiveofthetypeHfirm is to maximize the expected long-term (time 3) value of the equity held by the entrepreneur. This is accomplished by maximizing the type H s value while minimizing the dilution in the entrepreneur s equity holdings in the firm. This, in turn, is achieved by ensuring that the firm is able to raise the optimal amount of external capital, whileseparatingitselffromlowertype(typemandtypel) firms. The type H can use three alternative signals to accomplish this: (1) raising less capital externally than the amount thatwouldberaisedinafull-informationsetting(underfinancing), with the resulting underinvestment in its new project; 19 (2) expending resources on advertising; and (3) underpricing the firm s equity in its IPO. Denote by Π k, k {H, M, L} the entrepreneur s objective function given that his firm is of type k. Further, let V k represent the firm value at time 3; C k the external capital raised by the firm in the IPO market, and Ik 0 and I1 k the amounts invested by the firm in the existing project (at time 0) and the new project (at time 1), respectively. Further, denote Π k(j) and V k(j) the type k firm s objective function and total firm value, respectively, if it is perceived as a type j, wherek, j {H, M, L}; k 6=j. Finally, let F k, represent the value of the entire equity of the firm at the IPO price. Then, the type H firm s problem is given by: Max A H,F H,I H,C H Π H = V H µ 1 C H, (1) F H subject to the incentive compatibility (IC) constraints which ensure that both the type M and type L firms do not mimic it: Π M = V M µ 1 C M F M Π L = V L µ 1 C L F L µ Π M(H) = V M(H) 1 C H F H µ Π L(H) = V L(H) 1 C H F H, (2), (3) and the feasibility constraints which ensure that the sum of the firm s investments in its existing and new projects do not exceed the total capital available at each point in time: I 0 H + I 1 H W + C H A H, (4) I 0 H W A H. (5) 19 We assume that the amount raised by the firm in its IPO is publicly observable, as is the case in practice. Given the observability of the amount raised, outsiders can also infer the investment level chosen by the firm. Therefore, throughout this paper, we will use the terms underfinancing and underinvestment interchangeably. 12

15 In any separating equilibrium, the firm cannot overprice equity in its IPO, since, otherwise, there would be no demand for its equity. This market rationality constraint is given by: F k V k, (6) where F k < V k implies that a firm underprices equity in its IPO. In the following analysis, we define an underpricing factor f k = F k V k, which measures the extent of underpricing in the IPO. 20 The solution to the above problem involves the type H firm choosing that combination of signals which minimizes firm insiders aggregate signaling cost. In order to understand the trade-off driving the type H s equilibrium choice of signals, it is useful to study the cost of each signal separately. Consider first the case where the type H firm attempts to use underfinancing in the IPO market alone as a signal. In this case, it will have to cut back on investment in its new project, thus losing part of its value. If the type M or type L firm chooses to mimic the type H, they will also have to incur a similar loss in value as the type H firm. However, this cost in firm value due to underfinancing is partially offset by the reduced dilution in the entrepreneur s equity that results from the firm raising a smaller amount of external financing. The benefit from this reduction in dilution is greater for the type H firm (since its intrinsic value is greater) than for the type M or the type L firm, thus allowing the type H to use underfinancing as a signal. Consider now the case where the type H firm attempts to use advertising alone as a signal. In order to advertise, the type H firm needs to cut back on investment in its existing project, thereby reducing firm value. This loss in value also results in an increase in the dilution of the entrepreneur s equity holdings in the firm. If thetypemortypelfirm attempts to mimic the type H, they will also have to incur a loss in firm value of similar magnitude to the type H. However, given that the intrinsic value of the type H is greater than that of the type M or type L, this dilution in insiders equity holdings will always impose a greater cost on the type H firm compared to that on the type M or type L firm. Thus, advertising alone will be a costlier signal compared to underfinancing. Finally, consider the case where the type H attempts to signal using IPO underpricing alone. Given that the underpricing of a firm is not directly observable by outsiders (recall that only the IPO share price is observable), 20 Thus, optimally, the type H would like to choose the signal that reduces Π L(H) and Π M(H) the most while reducing Π H the least (i.e., to achieve the maximal effect on the type L and the type M while incurring the smallest signaling cost). Mathematically, if we define s as the signal chosen, then the type H chooses s such that Π H / s Π and H / s are the lowest. Π L(H) / s Π M(H) / s 13

16 the type H can use underpricing as a signal only by pricing its equity below the intrinsic value of a type M firm (if it wishes to prevent the type M from mimicking) or below the intrinsic value of a type L firm (if it wishes to prevent both the type M and the type L from mimicking). Further, given the type H firm s higher intrinsic value, the cost arising from the dilution in insiders equity holdings resulting from underpricing is greater for the type H firm than the corresponding cost to a type M or type L firm if they attempt to mimic the type H. This means that underpricing alone will be a costlier signal to the type H than either underfinancing or advertising. Given the relative cost of the three possible signals discussed above, the equilibrium (least-cost) combination of these signals is determined as follows. If the extent of underfinancing required to deter mimicking by the type M or type L results in the type H firm cutting back on investment in its new project only in the low productivity range of its investment opportunity set, then it will use underfinancing alone as a signal. However, if the extent of underfinancing required to deter mimicking by lower firm types is so large as to require the firm to cut back on investment in the high productivity (as well as low productivity) range of investment in its new project, the type H firm can minimize its aggregate cost of signaling by adding either advertising alone or both advertising and underpricing to the equilibrium signaling mix, depending on the amount of internal capital available to it. If the internal capital available is large enough that the firm can fund the required amount of advertising by cutting back only on the low-productivity range of investment in its existing project, then it will add only advertising to the signaling mix. If, however, the internal capital available is small, so that it has to cut back also on the high productivity range of investment in its existing project to fund the required amount of advertising, then the type H firm will add both underpricing and advertising to the signaling mix. 21 In the rest of the paper, we wish to focus on the more interesting cases where advertising or underpricing (or both) enters the equilibrium mix of signals (in other words, the type H and type M do not find it optimal to signal using underfinancing alone). This will be the case when the investment opportunity set available to thetypehandtypemfirms is such that they will always have to cut back on the high productivity range 21 The benefit tothetypehfirm from separating itself from the type M and type L firms is that it will be able to obtain its true value in the equity market, thus reducing the dilution in the entrepreneur s equity holdings at the time of the firm s IPO. An equilibrium where the type H firm separates itself from the type M and type L firms will exist here, since the above benefit to the type H firm will be greater than the benefit to the type M and type L firms from mimicking it. This is due to two reasons. First, given the type H firm s higher intrinsic value, the signaling benefit of the reduction in dilution in the entrepreneur s equity holdings is greater for the type H compared to the type M or the type L. Second, recall that the products of the type M and type L firms (being of poor quality) may break down between the two rounds of sales with a certain probability, while the type H firm s product (of superior quality) has zero breakdown probability. Thus, if a type M or type L firm attempts to mimic the type H by using the same signal, they may not be able to reap the full benefits of doing so, since the breakdown of their product between the two rounds of sales may reveal their true quality. 14

17 of investment in their new project if they are to signal using underfinancing alone. This is guaranteed by the following parameter constraint, which will be assumed to hold throughout the paper: i 2 i 1 < The Type M Firm s Problem i 1 (g b)min(2i 1,W + i 1 ) (b 1)[2R S Q + bmax(0,w i 1 )+gmin(2i 1,W + i 1 )]. (7) Clearly,theequityvalueofthetypeHfirm will be higher than that of the type M in a full information setting, while the equity value of the type L will be lower than that of the type M. This implies that the type HhasnoincentivetomimicthetypeM,whilethetypeLhassuchanincentive. Thus,thetypeMchooses the least-cost combination of advertising, underpricing, and underfinancing to distinguish itself from the type L, thus signaling its true value to the financial market. The type M therefore maximizes: µ Π M = V M 1 C M, (8) F M subject to feasibility constraints similar to (4) and (5), the IC constraint that the type L firm does not mimic: µ Π L = V L 1 C µ L Π L(M) = V L(M) 1 C M, (9) F L F M and the IC constraint ensuring that the type H does not mimic, which is satisfied trivially. The trade-offs facing the type M in choosing the optimal combination of signals to deter mimicking by the type L is similar to the trade-offs discussed earlier in the context of the type H firm. However, while the type H firm is concerned about the type L mimicking it in terms of both product quality and project value, the type M is concerned about the type L mimicking it only in terms of project value (since the product qualities of the type M and type L firms are the same). 3.2 Benchmark Equilibria Before we begin our analysis, it is worth keeping two benchmark cases in mind. 22 Consider first the case where there is no asymmetric information in either the product or the financial market. In this case, no firm type advertises, since the only reason for advertising in our setting is to signal firm type. Consider now the case where the product market is characterized by asymmetric information, but the firm does not raise capital in the financial market. In this case, firms with a superior product use advertising to signal their quality to the 22 Due to space limitations, we will provide only brief and intuitive discussion of these benchmark equilibria here. Explicit characterizations of these equilibria are given in the working paper version of this article. 15

18 product market, though (in general) to a lesser extent than in a situation where they intend to raise capital in the financial market (as we discuss in more detail in later sections). 3.3 Equilibria with Asymmetric Information in Both the Product and Financial Markets We now study the situation where, in addition to selling its products in the product market, the firm proposes to raise new equity, with both product and financial markets characterized by asymmetric information Equilibrium with Advertising But No Underpricing When the type H and type M firms have relatively large amounts of internal capital available, the leastcost combination of signals involves the firm advertising in the product market and underfinancing (i.e., raising an amount less than the full-information optimal amount) in the IPO market, but does not involve any IPO underpricing. We characterize this equilibrium below. Proposition 1 (Equilibrium with Advertising and Underfinancing) When the internal capital available W a 2 + i 1, the equilibrium in the financial and product markets involves the following: The type H firm: It spends an amount a 2 on advertising, raises an amount i 1 (less than i 2,thefullinformation optimal level) from its IPO, and invests amounts of (W a 2 ) and i 1 in its existing and its new projects, respectively. It prices its equity in the IPO at its intrinsic value. The type M firm: Itspendsasmalleramounta 1 on advertising, raises the same amount i 1 from its IPO, and invests amounts of (W a 1 ) and i 1 in its existing and its new projects, respectively. It prices its equity in the IPO at its intrinsic value (a 1 and a 2 are defined in the appendix). ThetypeLfirm: It does not advertise, raises an amount i 2 from its IPO, and invests amounts of W and i 2 in its existing and its new projects, respectively. It prices its equity in the IPO at its intrinsic value. All three types of firms price their products at their true (intrinsic) value to consumers. 23 WhenthetypeHandtypeMfirms have enough internal capital available, they can fund their advertising expenditures by reducing their investment only in the low productivity range of their existing project. This means that the opportunity cost of using advertising as a signal is lower than that of using underpricing. Further, thetypehandtypemfirms do not find it optimal to deter the type L from mimicking by using underfinancing alone, since this would be too costly for them. Thus, in equilibrium, both types of firms use a combination of product market advertising and underfinancing to signal their types. In equilibrium, the type H advertises more than the type M because information asymmetry exists about its product quality as well as its project value. This asymmetric information creates an incentive for both the type M and type L (which have poor quality products) to mimic the type H (which has superior quality products). 23 In equilibrium, the market infers a type H firm with probability 1 if the firm incurs an amount a 2 on advertising; infers a type M firm with probability 1 if the firm incurs an amount a 1 on advertising; and infers a type L firm with probability 1 if the firm does not advertise or advertises any amount other than a 1 or a 2. 16