Evidence on What CFOs Think About the IPO Process: Practice, Theory, and Managerial Implications

Transcription

1 Evidence on What CFOs Think About the IPO Process: Practice, Theory, and Managerial Implications by James C. Brau and Stanley E. Fawcett, Brigham Young University 1 any privately held companies aspire to go public M through an initial public offering (IPO). There are two obvious benefits: First, an IPO can put a great deal of capital into the company s coffers. Second, a successful IPO can generate tremendous wealth for company insiders and pre-ipo investors. In recent years, IPOs have raised billions of dollars for issuing firms, created a multitude of millionaires, and generated considerable excitement among the media. But going public is not an easy process, nor is it without costs. Many companies have begun the IPO process only to withdraw the offering, often confused and frustrated by the experience. To improve decision-making and to mitigate many of the uncertainties managers need a clear picture of the core issues involved in the IPO process. With this as motivation, we constructed a theoretical-based survey instrument and surveyed 336 CFOs to get their insights into the IPO process. We studied six specific aspects of the IPO process: (1) motives for going public; (2) the timing of IPOs; (3) criteria for choosing an underwriter; (4) IPO underpricing; (5) IPO signaling; and (6) reasons to stay private. Where possible we also attempted to add extra insight by stepping outside of the survey data to test managerial behavior. By surveying CFOs to obtain a real-world perspective of the IPO process, we can also compare their beliefs and experiences to both academic theory and the findings of empirical research. Doing so allows us to identify the gaps between theory and practice, and to begin to bridge those gaps through better communication and more targeted research. In many areas, we find harmony between CFO beliefs and academic theory. But in several key areas, we find that CFO perceptions diverge in significant ways from traditional academic theory. The main findings from the survey are summarized below: The primary motive for going public is to fund growth opportunities. More specifically, IPOs create a currency publicly-traded shares that can be used to grow through acquisitions. CFOs strongly base the timing of their IPOs on overall stock market conditions, while paying least attention to IPO market conditions. Yet empirical evidence shows that IPO market conditions, particularly within industry, are strongly related to timing. CFOs choose underwriters based on their overall reputation and the underwriter s industry expertise. Surprisingly, issuers were not very concerned about the underwriter fee structure, perhaps indicating general acceptance of the typical 7% spread. CFOs view underpricing mainly as a means of compensating investors for taking on the risk of the IPO. They typically do not believe that underpricing is a result of practices such as spinning or flipping that are often criticized as being detrimental to issuers. The two strongest perceived positive signals for issuer quality are a history of strong earnings and a top investment bank. The strongest negative signal is the sale of insider shares in the IPO. The primary reason cited for staying private is a desire to maintain decision-making control. The IPO process is time-consuming, expensive, and fraught with uncertainty. Getting it wrong can set a company back a year or more, highlighting the importance of being well-informed and prepared. The survey results suggest that most CFOs have a good understanding of the issues, and the divergence between the findings and the theory may be a matter of semantics more than anything else. Nonetheless, we offer some recommendations on key points that CFOs need to consider as they think about and actually undertake an IPO. The Survey Our survey targeted three distinct groups: (1) CFOs of companies that had successfully completed an IPO from January 2000 through December 2002; (2) CFOs of companies that had filed a prospectus to go public in the same time period, but then subsequently withdrew the offering; and (3) CFOs of private firms that were large enough to go public in the same time period, but chose not 1. This article draws on and uses the same dataset as our paper Initial Public Offerings: An Analysis of Theory and Practice, Journal of Finance, Vol. 61 (2006). Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer

2 Figure 1 Survey Evidence on the Motivations for Going Public to. A total of 336 CFOs responded to the survey, with 87, 37, and 212 responses for the three aforementioned groups, respectively. A detailed description of the survey method is provided in the appendix. Motives for Going Public Scarcity of data has limited empirical investigation into perhaps the most fundamental question about the IPO process: Why do companies choose to go public? Several theories have been advanced in the academic literature. Most such theories begin with the assumption that markets are efficient and that managers aim to maximize firm value. Given such assumptions, the principal reason for companies to go public is to raise capital to fund investment opportunities and to raise that capital in a way that minimizes the company s weighted average cost of capital. 2 A second motive, not necessarily consistent with either market efficiency or value-maximizing behavior by the issuers, is to allow insiders to cash out, presumably at the highest price possible, and perhaps diversify their holdings. 2. See J. Scott, A Theory of Optimal Capital Structure, Bell Journal of Economics, Vol. 7 (1976) and F. Modigliani and M. Miller, Corporate Income Taxes and the Cost of Capital: A Correction, American Economic Review, Vol. 53 (1963). An alternative theory, known as the pecking order theory, suggests that insiders conduct IPOs to gain access to capital when other, cheaper sources of capital (such as internal equity and debt) have been exhausted. See S. Myers, The Capital Structure Puzzle, Journal of Finance, Vol. 3, (1984) and S. Myers and N. Majluf, Corporate Financing and Investment Decisions when Firms have Information that Investors do not Have, Journal of Financial Economics, Vol. 13 (1984). Using variations of these two basic motives, and of the assumptions underlying them, we were able to come up with ten different possible motives for going public. We then asked CFOs to evaluate the importance of each of these ten motives. The CFO responses, as summarized in Figure 1, yielded two surprises. First is the relatively low importance CFOs appear to place on using an IPO to minimize the cost of capital, which ranked only sixth among reasons for going public. Second, two related questions received the weakest CFO endorsement: our company has run out of private equity (28% agree) and debt is becoming too expensive (14% agree). Also contrary to the standard academic trade-off theory of optimal capital structure, neither costof-capital nor capital availability arguments were explicitly recognized as the main drivers of the going-public decision. Nevertheless, the motive that was cited by the highest percentage of CFOs (nearly 60%) the creation of public shares for use in future acquisitions can be readily interpreted as a means of raising equity capital to fund growth opportunities. 3 Having publicly traded stock enables compa- 3. Funding acquisitions is consistent with theory insofar as theory says IPOs provide low-cost equity for funding growth. See M. Barclay and C. Smith, The Capital Structure Puzzle: Another Look at the Evidence, Journal of Applied Corporate Finance, Vol. 12 (1999), who showed that equity is an appropriate vehicle for companies with growth opportunities. Many IPO firms are companies with growth strategies that want equity, especially for stock swap mergers. 108 Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer 2006

3 Figure 2 Survey Evidence on the Timing of IPOs nies to participate in the M&A market by providing them with a currency for acquiring other firms. 4 What s more, the only other rationale to receive majority support from CFOs the opportunity to establish a market price can also be viewed as the first step in the acquisition process. 5 To further explore acquisition motives, we stepped outside of the survey data and investigated M&A activity for our sample of IPOs, comparing it to a benchmark portfolio of already public companies. 6 We found that, after going public, our 87 IPO firms acquired a total of 141 companies, while only 18 of the IPO firms became targets. Furthermore, the 141 acquisitions by our IPO firms compared to only 96 acquisitions by pair-matched non-ipo benchmark companies, suggesting that IPOs are designed at least in part to facilitate acquisition activity. Thus, going public appears to be a critical step in acquisition-based growth strategies for many companies. An IPO is one way for the firm insiders to achieve their goals of either cashing out or raising capital, but another way is to be acquired. Depending on the circumstances, this may be a more attractive option than an IPO, but at a minimum the two should be considered simultaneously. Although an academic study (involving one of the current authors) has shown that insiders in a takeover do not appear to receive as high a payoff as IPO insiders (in comparable cases), takeovers will decrease the risk assumed by the exiting insiders. 7 In a follow-on study, the same authors also showed that if insiders choose a dual-track strategy (filing for an IPO at the same time as courting acquirers), the takeover discount can be sharply lowered. 8 Managers intent on raising additional capital should also consider private placements of debt or equity, which may be less costly than an IPO. One final observation: companies that have never attempted an IPO view the corporate motives for going public differently from their counterparts. Specifically, the motive for going public most cited by not-tried CFOs is the opportunity for principals to cash out and diversify their holdings (a motive that ranked only sixth and eighth for successful and withdrawn IPOs, respectively). Also notable, the CFOs of not-tried companies claim to be less concerned about their company s perceived market value or reputation than CFOs whose firms had either contemplated or done an IPO. The Timing of IPOs A second important question is the timing of an IPO. Here there are two main explanations, again with multiple variations on each. The life-cycle theory argues that, as a company grows, at some point it is more economical for it to obtain external equity financing through an IPO. The timing decision is thus a natural consequence of a company s maturation. According to this theory, companies go public when they reach a point in their life cycle where they need an IPO to raise equity to fund growth and create a public and liquid market for firm ownership. The second line of reasoning emphasizes market timing. The argument here is that insiders use their superior infor- 4. This finding is consistent with J. Brau, B. Francis, and N. Kohers, The Choice of IPO versus Takeover: Empirical Evidence, Journal of Business, Vol. 76 (2003). 5. See A. Mello and J. Parsons, Going Public and the Ownership Structure of the Firm, Journal of Financial Economics, Vol. 49 (1998) who argue, Viewing the IPO as a step in a more complete process of selling the firm is the result of considering the inherent asymmetry of investors together with the strategic behavior on the part of the seller. 6. The data for this follow-on analysis was obtained from SDC s M&A database through the end of July See J. Brau, B. Francis, and N. Kohers, The Choice of IPO versus Takeover: Empirical Evidence, Journal of Business, Vol. 76 (2003) for a complete analysis of IPO versus takeover. Also see A. Poulsen, and M. Stegemoller, Moving from Private to Public Ownership: Selling out to Public Firms vs. Initial Public Offerings, University of Georgia, Working paper (2005), for a more recent study of the IPO versus takeover decision. 8. See J. Brau and N. Kohers, Dual-Track versus Single-Track Sell-Outs: An Empirical Analysis of Competing Harvest Strategies, Brigham Young University, Working paper (2006). Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer

4 mation about the firm s prospects to exploit windows of opportunity by issuing shares that, if not overvalued, are at least sufficiently fully valued to avoid dilution of the existing shareholders claims. 9 How insiders define such windows is a source of debate. Some academics suggest they look at general market conditions as the gauge. Others argue that industry conditions are the driving factors. Still others claim it is the momentum of the IPO market that matters. Through our questions, we attempt to disentangle the main driver overall market, industry, or IPO market of issuing windows. 10 The CFOs were asked which factors most influenced the timing of their (possible) IPO. As summarized in Figure 2, the CFO responses indicate that issuers are clearly opportunistic in timing their IPOs. First of all, while 66% of CFOs said they were raising capital to fund continued growth, 83% indicated that overall stock market conditions were the primary determinant in timing their IPOs. These insiders thus appear to target windows of opportunity to maximize the share value and the amount of money that can be raised through the IPO. And the CFOs of venture capital-backed IPOs were particularly intent on exploiting temporary windows of opportunity. Moreover, 83% of CFOs said they defined these windows in terms of overall stock market conditions, while 70% also said that general industry conditions play a role in their timing decisions. By contrast, indicators closely related to IPO market conditions were said to receive very little CFO attention. This was true of the CFOs of all but the smallest firms, which claim to rely more heavily on other quality firms going public as a reliable guide to good timing. The CFOs response that IPO market conditions are largely irrelevant is at odds with empirical research, which generally finds that IPO market factors such as underpricing, especially within an industry, are a significant determinant of the timing decision. An explanation for this contradictory evidence may be that while CFOs focus on broad market conditions, their investment bankers follow the IPO market closely, and the underwriters have a significant effect on the final timing decision. Moreover, CFOs might be wise to look closely at IPO market conditions because they provide a good indication of the valuation investors will likely assign their company. One study found that selecting comparable multiples such as P/Es or priceto-sales ratios from recent IPOs to determine a value for the current IPO leads to more accurate pricing than the use of industry-based comparable multiples. 11 To the extent the shares issued in an IPO prove to be overpriced, timing the issue to exploit windows of opportunity clearly benefits insiders and pre-ipo investors at the cost of new shareholders. Although a matter of debate, many researchers believe that IPOs have underperformed on a risk-adjusted basis over the long run in many countries, including the U.S. 12 But this, of course, begs the question: If successful market timing by issuers implies low returns, on average, for investors who buy early in the secondary market, why do outside investors continue to be hungry for IPOs? We argue that IPO investors are seeking not so much average returns as the possibility of home runs. A line of academic research provides both a theoretical argument and some supporting evidence that investors often willingly accept lower average pay-offs on securities that offer higher probabilities of a big pay-off. 13 Selecting an Underwriter Choosing the right underwriter can greatly enhance the going public process. The underwriter performs a variety of roles, perhaps the most important of which is to generate market visibility and interest in the offering. To help make this marketing effort successful, the underwriter coaches the company and assists in the preparation of the offering prospectus so it meets SEC requirements and looks attractive to potential investors. During the marketing stage, the company s officers go on roadshows to pitch the IPO. Underwriters provide vital guidance throughout this process and build the book of orders by gauging the level of interest of major institutional investors. After the IPO, the underwriter usually provides liquidity, often as a market maker, to maintain the stock s strength and build momentum for the future. We asked the CFOs to indicate How important are/ were the following criteria in selecting a lead IPO underwriter? 14 Figure 3 reports their responses. Issues that affect the underwriter s principal intermediary role the ability to provide the expertise needed to successfully complete the IPO dominate the selection process. CFOs are primarily interested in the underwriter s overall reputation (91% agree), industry expertise (88%), and research capability and 9. See T. Loughran and J. Ritter, The New Issues Puzzle, Journal of Finance, Vol. 50 (1995) for a discussion and evidence of windows of opportunity. 10. See D. Lucas and R. McDonald, Equity Issues and Stock Price Dynamics, Journal of Finance, Vol. 45 (1990); J. Ritter and I. Welch, A Review of IPO Activity, Pricing, and Allocations, Journal of Finance, Vol. 57 (2002); M. Pagano, F. Panetta, and L. Zingales, Why Do Companies Go Public? An Empirical Analysis, Journal of Finance, Vol. 53 (1998); M. Lowery, Why Does IPO Volume Fluctuate So Much?, Journal of Financial Economics Vol. 67 (2002); M. Lowery and W. Schwert, IPO Market Cycles: Bubbles or Sequential Learning?, Journal of Finance Vol. 57 (2002); and H. Choe, R. Masulis, and V. Nanda, Common Stock Offerings Across the Business Cycle: Theory and Evidence, Journal of Empirical Finance, Vol. 1 (1993). 11. See. M. Kim and J. Ritter, Valuing IPOs, Journal of Financial Economics, Vol. 53 (1999). 12. See T. Loughran, J. Ritter, and K. Rydqvist, Initial Public Offerings: International Insights, Pacific-Basic Finance Journal, Vol. 2 (1994) and T. Loughran and J. Ritter, The New Issues Puzzle, Journal of Finance, Vol. 50 (1995). 13. In statistical language, IPO investors seem to have a preference for right-skewed distributions of returns. For a discussion of skewness preference among investors, see T. Mitton and K. Vorkink, Equilibrium Underdiversification and the Preference for Skewness, Review of Financial Studies, forthcoming. 14. We obtain this question from L. Krigman, W. Shaw, and K. Womack, Why do Firms Switch Underwriters?, Journal of Financial Economics, Vol. 60 (2001). 110 Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer 2006

5 Figure 3 Survey Evidence on Reasons for Selecting an Underwriter quality (83%). Two other criteria received majority support: the institutional client base (57%) and the market-making and trading-desk capabilities of the underwriter (56%). Other criteria such as pricing and valuation promises, fee structure, the underwriter s retail client base, and the availability of non-equity-related services received much less CFO attention. What do these findings imply? First, the importance of industry expertise highlights a role for boutique underwriters who specialize in certain sectors or industries. Second, CFOs appear to care much more about institutional investors than they do about retail investors, and to believe that if a capable and reputable underwriter is selected, the stock valuation and pricing will be reasonable. Third, CFOs appear to trust the work of highly reputable investment banks and are willing to pay for their services. For many CFOs, reputation appears to be a surrogate for an extensive selection process, reducing the need to conduct costly analysis of an underwriter s capability. Our findings here also suggest that the fee structure is not a major factor in choosing an underwriter and our subsequent finding (reported in Figure 6) that CFOs do not consider the costs of paying prestigious underwriters as a barrier to going public are also of interest. The CFO responses suggest that they feel they are receiving a service commensurate to the fees paid. A recent academic study suggests that, by using the bookbuilding method, underwriters (1) reduce risk for both issuers and investors and (2) control spending on information acquisition, thereby limiting either underpricing or aftermarket volatility. 15 One qualification does surface in the subsample tests. Although not-tried CFOs also pay close attention to overall underwriter reputation, they are somewhat skeptical of the underwriting process. To overcome this skepticism by potential clients, investment banks may consider making the IPO process more transparent. CFO Perceptions of IPO Underpricing IPO underpricing occurs when the offer price is lower than the first-day market closing price. 16 The average underpricing for U.S. IPOs during the period was 18%, which means that primary market investors who received an IPO allocation earned an average immediate one-day return of 18%. 17 The widespread existence of underpricing suggests that money is consistently left on the table by the issuing companies. 18 If the goal is to maximize the amount 15. See A. Sherman, Global Trends in IPO Methods: Book Building versus Auctions With Endogenous Entry, Journal of Financial Economics, (forthcoming). 16. See R. Ibbotson, J. Sindelar, and J. Ritter The Market s Problems with the Pricing of Initial Public Offerings, Journal of Applied Corporate Finance, Vol. 7 (1994) for a discussion of three IPO phenomena, to include underpricing. 17. The median return over this period was 13.5%. For the time series of data on average monthly underpricing from 1960 through 2004, see Jay Ritter s website at: bear.cba.ufl.edu/ritter/index.html. 18. See J. Ritter, The Costs of Going Public, Journal of Financial Economics, Vol.18 (1987) for a discussion of underpricing as a cost to issuers. Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer

6 Figure 4 CFO Perceptions of IPO Underpricing of capital that is raised through an IPO, the obvious question is, Why does underpricing exist? We also attempted to determine the extent to which CFOs expectations about underpricing are realistic. Focusing first on expectations, we asked CFOs what level of underpricing they expected prior to the offer. The median level of expected underpricing was 10.0%. This expectation compared to an actual median of 13.5%. Thus, with the exception of a few outliers, CFOs appear to be well-informed about the level of underpricing. Academics have put forth a great deal of effort to explain why underpricing exists. Many of the proposed theories argue that underpricing is due to asymmetric information the possibility that managers are better informed than investors, or that some investor groups are more informed than others. One much cited theory says that, when relatively uninformed investors (say, retail investors) are bidding against sophisticated well-informed investors ( institutions ), the former face a potential winner s curse the possibility that they will receive allocations of mainly just overpriced IPOs. According to this theory, underpricing is necessary to induce these uninformed investors to bid, given their vulnerability to overpricing. 19 Another information-based theory argues that sophisticated investors must be compensated through 19. See K. Rock, Why New Issues are Underpriced, Journal of Financial Economics, Vol. 15 (1986). 20. See L. Benveniste and P. Spindt, How Investment Bankers Determine the Offer Price and Allocation of New Issues, Journal of Financial Economics, Vol. 24 (1989) and L. Benveniste and W. Wilhelm, A Comparative Analysis of IPO Proceeds Under Alternative Regulatory Environments, Journal of Financial Economics, Vol. 28 (1990). underpricing for revealing their true demand for the issue during the bookbuilding process, a necessary step for building demand in the offering. 20 Other underpricing theories have been advanced that rely on different assumptions, some of which form the basis of questions we posed to CFOs. Figure 4 reports CFO responses when asked why underpricing exists. Among the numerous theories the CFOs were asked to evaluate, there was one clear favorite that underpricing compensates investors for taking on the risk of the IPO (60% agree). The supporting logic for this choice is as follows: Because the initial secondary market price is uncertain when the primary market price is set, IPO investors bear risk that would otherwise be borne by issuers or their underwriters. In this sense, primary market investors are effectively insuring issuers against the possibility of an adverse secondary market reception. Underpricing is the premium charged by investors for providing such insurance. In sum, CFOs attributed most of the underpricing to market uncertainty and the lack of perfect information. At the same time, however, a large minority (42%) expressed some suspicion that underwriters seek to opportunistically profit from underpricing by currying favor with institutional investors. Even so, the low scores for flipping and spinning suggest that CFOs place a great deal of trust in their under- 21. Flipping occurs when investors who received an allocation in the offering immediately sell the shares in the secondary market. Spinning is the practice of allocating shares in hot offerings to senior executives in other companies in order to curry favor for future investment banking business. 112 Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer 2006

7 Figure 5 Survey Evidence of IPO Signaling writers and the underwriting process. 21 The bottom line may be that most executives are not greatly troubled by underpricing and accept it as a cost of going public. On the other hand, the emergence of a few high-profile firms choosing to price their IPOs through Dutch auctions instead of traditional bookbuilding may indicate a degree of issuer dissatisfaction with underpricing. For example, Google and Morningstar both completed successful IPOs using the auction method. Although IPO auctions have received more attention of late, they have been relatively rare events. 22 For example, WR Hambrecht, a firm that specializes in bringing firms to market through the Dutch auction method, has managed only 14 IPOs since its start in It is interesting that according to SDC data, although Google used an auction system to price its IPO, it still experienced 18% underpricing (measured from offer price of $85 to $ on the day after the offer). For the full 11 IPOs for which WR Hambrecht has acted as the single lead underwriter since its creation in 1999, the auction system has averaged underpricing of 35%. 24 But this 35% is somewhat misleading since when we remove the effect of a single outlier (Andover.net, which experienced 330% underpricing), the average underpricing of the remaining 10 firms underwritten by Hambrecht drops to 5.8%. However, due to the small number of U.S. IPO auctions to date, it is not possible to make any definitive comparisons between bookbuilding and auctions. 25 One thing CFOs can do to minimize the underpricing is to be more aggressive in negotiating the IPO offer price with the underwriter. A recent study found that approximately 75% of IPOs between 1981 and 2000 had exact integer offer prices (round dollar). 26 These IPOs experienced on average 25% underpricing, whereas the non-integer priced IPOs (say, $9.50) experienced only 8% underpricing. Formal tests support the assertion that tougher negotiation by the issuing firms (as indicated by the non-integer offer prices) reduced the underpricing of their issues. IPO Signaling Outside investors typically know little about a company when it begins the IPO process. So although the SEC requires a detailed offering prospectus, company insiders possess far more information about the firm than these 22. Auctions have been tried more extensively in countries other than the U.S., but their track record of success is very poor. Most countries that experimented with auctions have since abandoned them, with few using them at all anymore. For a discussion of why that s the case, see Ravi Jagannathan and Ann Sherman, Reforming the Bookbuilding Process for IPOs, Journal of Applied Corporate Finance Vol. 17 (2005), pp See S. Syre, The IPO Path Less Taken, Boston Globe (Sept 1, 2005) for a discussion of IPO auctions. Our number of 14 IPOs is from the SDC database. 24. SDC indicates the 11 IPOs are: Ravenswood Winery, Salon.com, Andover.net, Nogatech, Peet s Coffee & Tea, Briazz, Overstock.com, RedEnvelope, Genitope, New River Pharmaceuticals, and Morningstar. The three firms that have been co-led by WR Hambrecht are Sunset Financial Resources (with JP Morgan), Bofl Holding (with Seidler) and Hemo- Sense (with Lazard Capital Markets). We use SDC offer price and first day close data. 25. Another difficulty with making a straight comparison between bookbuilding and auction underpricing is that it does not control for the various factors that affect underpricing, such as firm and offer size, risk, underwriter reputation, etc. 26. See D. Bradley, J. Cooney, B. Jordan, and A. Singh, Negotiation and the IPO Offer Price: A Comparison of Integer vs. Non-Integer IPOs, Journal of Financial and Quantitative Analysis, Vol. 39 (2004). Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer

8 Figure 6 Survey Evidence on Reasons Why Some Firms Choose to Stay Private investors. Recognizing that insiders may be timing the issue to sell overpriced stock, outside investors look for signals of firm quality. The idea behind signaling theory is that good firms take certain actions that bad firms are either unwilling or can t afford to take. One example of an attempt to signal quality is the use of lockups. Insiders in a high-quality issue may agree not to sell their shares for a long period of time after the IPO, confident that strong analyst ratings and good future earnings will propel the stock price higher. It s true that insiders in low-quality firms could try to mimic the strategy of a long lockup to garner a higher offer price, and effectively sell overpriced shares. But that would mean running the risk that, before the lockup expires, outside investors learn through analyst reports and earnings announcements that the firm is not as good as advertised, and the share price falls to its fair value. Insiders who knowingly hold shares in overvalued companies are unlikely to agree to a long lockup period. 27 What actions do CFOs perceive as reliable signals? We asked the CFOs to evaluate nine possible signals identified in the theoretical literature. As shown in Figure 5, the 27. For a complete discussion and theoretical model with empirical tests on this example of IPO lockups serving as signals, see J. Brau, V. Lambson, and G. McQueen, Lockups Revisited, Journal of Financial and Quantitative Analysis, Vol. 40 (2005). 28. See S. Teoh, I. Welch, and T. Wong, Earnings Management and the Long-Run Performance of Initial Public Offerings, Journal of Finance, Vol. 53 (1998) for a discussion of window-dressed IPO prospectuses and their impact on subsequent stock performance. most frequently cited signal of firm quality is a track record of strong historical earnings (91% agree). Past success is viewed as an indication of future returns and is a trait that cannot be easily imitated by lower quality firms. But there is a downside: the possibility that window dressing can make the numbers appear better than they really are. 28 The certification provided by an association with reputable financial intermediaries is also widely viewed as a very strong positive signal. A prestigious investment banker is the most positive signal (89% agree), followed by the use of a Big 4 accounting firm (74%) and the backing of a venture capital firm (40%). Finally, commitment to a long lockup (78%) and a large first-day stock price jump (73%) are also viewed as positive signals. This last observation that leaving a large amount of money on the table communicates a strong positive signal requires some comment. Evidently, CFOs are willing to bear the cost of underpricing because they feel it functions as valuable advertising. Although this may seem inefficient, it is consistent with the argument that high-quality firms can afford to sacrifice some value in the form of underpricing, whereas low-quality firms cannot See F. Allen and G. Faulhaber, Signaling by Underpricing in the IPO Market, Journal of Financial Economics, Vol. 23 (1989); T. Chemmanur, The Pricing of Initial Public Offers: A Dynamic Model with Information Production, Journal of Finance, Vol. 48 (1993); and I. Welch, Seasoned Offerings, Imitation Costs, and the Underpricing of Initial Public Offerings, Journal of Finance, Vol. 44 (1989). 114 Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer 2006

9 Yet several empirical studies have cast doubt on the efficacy of underpricing as a positive signal by showing that companies with greater underpricing are also less likely to return to the market to raise more equity capital and that firms with lower underpricing enjoy higher earnings and pay higher dividends. 30 Although the CFOs generally viewed a large first-day stock price jump as a positive signal, only 23% of them (see Figure 4) felt that a legitimate reason for underpricing was to increase publicity on the opening day. Thus, although CFOs appear to feel underpricing is a positive signal, they don t appear to assign much value to the signal. CFOs view three corporate actions sometimes associated with IPOs as negative signals to investors: (1) selling insider shares in the IPO (80% agree), (2) selling a large portion of the firm in the IPO (44%), and (3) issuing units (43%). The first two are perceived negatively because they raise the suspicion that insiders are rushing to cash out overvalued shares. 31 Of course, IPO insiders may still believe the shares are fairly (or even under) valued and may simply desire diversification. But if so, they should take efforts to communicate to potential investors why they need such diversification. Issuing units offerings in which warrants are attached to the shares of stock at issuance may signal that insiders believe that shares alone are not enough to successfully float the offer. 32 Why do Some Companies Choose to Stay Private? While the prospect of a successful IPO has captured the imagination of many managers, some companies simply are not interested in going public. We asked CFOs why not. Based on their responses, which are shown in Figure 6, company insiders choose to remain private for a variety of reasons. Not surprisingly, of all the questions posed in our survey, this one resulted in the greatest differences of opinion between the three subsamples (withdrawn IPOs, successful IPOs, and not-tried IPOs). The most cited reason in the complete sample to remain private is to maintain decision-making control (56% agree). 33 Among the CFOs, IPOs are believed to dilute ownership, giving insiders a smaller piece of the pie and perhaps reducing their control over important investment and operating decisions. As expected, such control issues were by far the most important concern for CFOs of companies that have never attempted to go public. For now, these CFOs were satisfied that they have enough capital to finance the firm s investments and operations and so perceived little value in going public. In the minds of CFOs, the second most important reason not to go public is outside the control of the company unfavorable market or industry conditions (48% agree). As we ve already seen, CFOs are opportunistic, wanting to take their companies public when an IPO will generate as much capital and wealth as possible. CFOs from the withdrawn sample were extremely sensitive to bad market/industry conditions (with 95% agreement). That such concerns were far more important than control issues is not surprising, since such firms had already at one point decided to go public. The CFOs from the companies that successfully completed the IPO process generally agree with their counterparts that control and timing were the most important issues considered as they approached the IPO process. The only other issue these CFOs considered truly important was concern about disclosing information to competitors. Most CFOs do not view the expenses of an IPO as a deterrent (only 27% cited as important ). And Sarbanes-Oxley, despite the hype in the media, received very low scores from all three groups of CFOs (only 19%). Conclusion Surveying CFOs about their views on the IPO process provides a window into their perceptions and understanding. It enables us to observe where perception might deviate from reality, and how this might lead to less than optimal decisions during the IPO process. When that appears to be the case, we have tried to offer specific recommendations of what can and should be done differently. Overall, most CFOs understood the basic issues involved in the IPO process and were comfortable with it, but there were specific details that they were not familiar with and interpretations at odds with available empirical evidence. For example, IPO market conditions have a strong influence on both timing and valuation, yet most CFOs look only at market or industry-wide performance. As a result, they may be ignoring useful information that could lead to a more successful offering. A desire to pursue acquisitions to spur growth facilitated by increased cash and a liquid stock was the number 30. For example, see R. Michaely and W. Shaw, The Pricing of Initial Public Offerings: Tests of Adverse-Selection and Signaling Theories, Review of Financial Studies, Vol. 7 (1994); J. Garfinkel, IPO Underpricing, Insider Selling and Subsequent Equity Offerings: Is Underpricing a Signal of Quality? Financial Management, Vol. 22 (1993); and N. Jegadeesh, M. Weinstein, and I. Welch, An Empirical Investigation of IPO Returns and Subsequent Equity Offerings, Journal of Financial Economics, Vol. 34 (1993). 31. These first two findings are consistent with the theoretical model of H. Leland and D. Pyle, Information Asymmetries, Financial Structure, and Financial Intermediation, Journal of Finance, Vol. 32 (1977). 32. See P. Schultz, Unit Initial Public Offerings: A Form of Staged Financing, Journal of Financial Economics, Vol. 34 (1993). 33. Not-tried CFOs strongly ranked decision-making control as their top reason. Successful CFOs ranked decision-making as their third choice, behind bad market/industry conditions and disclosing information to competitors. Withdrawn CFOs ranked decisionmaking fifth, behind bad market/industry conditions, low price of stock, already have enough capital, and officer liability. Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer

10 one reason cited for going public. But CFOs should also consider a dual-track process of filing for an IPO and courting acquirers; it raises the attainable value in a takeover and provides a ready alternative if the IPO market closes. Underpricing was a cost of going public that the CFOs readily accepted without much complaint. Yet they may have the ability to reduce the amount of underpricing and so raise the offer price. They can negotiate harder for a higher offer price, even if it s only for 50 cents, and avoid any actions, such as insider selling or too large an offering, that convey a negative signal. Finally, the positive signaling value of a large initial return may be quite limited, and thus more costly than it s worth. jim brau is an Associate Professor of Finance and the Goldman Sachs Faculty Fellow at BYU. stan fawcett is the Donald L. Staheli Professor of Business Management at BYU. Appendix: Survey Methods and Data To find out how CFOs view the IPO process, we conducted a mail survey using the Dillman Total Design Method, which has become a standard for conducting rigorous surveys. 34 After conducting a thorough review of the IPO literature, we carefully crafted questions to address theoretical and process issues. We pre-tested the survey with several key informants who are well-versed in the goingpublic process. Their feedback was used to improve the survey. As we built the survey, we constructed three separate mailing lists. We searched Thomson Financial s SDC New Issues Database to identify companies that had successfully completed an IPO from January 2000 through December We also searched SDC for firms that filed a prospectus to go public, but then subsequently withdrew the offering. Our third sample consisted of private firms that were large enough to go public, but chose not to conduct an IPO. This group of companies was compiled from Dun and Bradstreet and Reference USA and included the largest 1,500 nonfinancial privately held firms based on 2002 revenues. Our final mailing lists consisted of 340 successful IPOs, 179 withdrawn IPOs, and 1,266 non-tried IPO firms for which we could find accurate mailing information. Through three rounds of mailings we received completed surveys from 336 CFOs (212 not-tried (17% response rate), 87 successfully completed (26% response rate), and 37 withdrawn (21% response rate)). The aggregate response rate of 19% is considered excellent in financial research. Comparing the respondents to the sampling frame, we determined that the sample was representative of the overall population. The basic demographics for the sample are reported in Table 1. One concern with our sample may be the sample period was mostly a bear market. This Table 1 Sample Descriptive Statistics * Variable Mean Median Minimum Maximum Revenues ($ millions) ,020 Firm Age (years) High Technology (%) 19 Venture Capital Backed IPO (%) 58 Initial Return IPO > 10% (%) 54 Major SIC Industry description Group Frequency Percentage Agriculture, Forestry, and Fishing Mining Construction Manufacturing Transportation, Communications, Electric, Gas, and Sanitary Services Wholesale Trade Retail Trade Services *There are no finance (SIC = 60-67) or public administration (SIC = 91-97) firms in our sample. Four SIC codes could not be determined, reducing the industry statistics to a sample of See A. Dillman, Mail and Telephone Surveys: The Total Design Method (1978, New York: John Wiley & Sons) for a thorough discussion on survey methods. 116 Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer 2006

11 market condition begs the question: Can the results of our study be generalized to other time periods? In an attempt to determine if our sample is robust to other time periods, we asked the underwriter selection question directly from a previous Journal of Financial Economics study that dealt with why firms switch underwriters. 35 Our data from held close correlation to the earlier study replies which were from , suggesting that CFO sentiment (at least for this one issue) is robust between the two periods. Because our study is unique, it is not possible to compare the other questions to extant survey responses. Whereas our results may not be 100% replicable in different market conditions, we do feel that the majority of the results can be generalized to other time periods. For example, the CFO opportunistic mindset of timing the offer should not change across time. Similarly, issuing to facilitate M&A should be just as valid in the current market as in the paper s sample period. 35. See L. Krigman, W. Shaw, and K. Womack, Why do Firms Switch Underwriters?, Journal of Financial Economics, Vol. 60 (2001). Journal of Applied Corporate Finance Volume 18 Number 3 A Morgan Stanley Publication Summer