Initial Public Offerings: An Analysis of Theory and Practice Abstract

Transcription

1 Initial Public Offerings: An Analysis of Theory and Practice 6 Abstract We design and administer three sets of surveys to firms that 1) have recently attempted to go public and withdrew the offer, 2) firms that have recently successfully completed an initial public offering (IPO), and 3) private firms that are big enough, but choose not to attempt an IPO. We first discuss the theory that drives each survey question and then report and analyze the survey results for our sample of 336 chief financial officers who completed surveys. We explore many of the issues in the extant IPO literature by comparing practice to theory and discover several interesting insights.

2 Initial Public Offerings: An Analysis of Theory and Practice We design and administer three sets of surveys to firms that 1) have recently attempted to go public and withdrew the offer, 2) firms that have recently successfully completed an initial public offering (IPO), and 3) private firms that are big enough, but choose not to attempt an IPO. We first discuss the theory that drives each survey question and then report and analyze the survey results for our sample of 336 chief financial officers who completed surveys. We explore many of the issues in the extant IPO literature by comparing practice to theory and discover several interesting insights. I. Introduction Great headway, both theoretical and empirical, has been made to understand managerial actions in the initial public offering (IPO) process. The IPO literature is becoming well-developed. In this study, we extend the existing literature by surveying chief financial officers (CFOs) to directly ask them how they perceive academic theories pertaining to the process of going public. Our research design is similar to that of Graham and Harvey (2001) who surveyed CFOs to compare corporate finance practices to academic theories. In addition to the survey data, we analyze publicly available data (e.g., returns and prospectus data) to gain additional insights and understand better the IPO process and the relevance of the existing IPO literature. The persistent questions in the IPO literature that we examine are: 1) Why do firms go public or choose to stay private?, 2) Why is the offering price of an IPO usually less than the market price of the stock at the end of the first day? (underpricing), 3) What issues impact the timing of when firms choose to go public? (hot markets), 4) Why do IPOs tend to underperform in the long-run?, 1

3 5) How does certification impact IPOs? (e.g., venture capitalists and prestigious underwriters), 6) What actions by insiders are considered positive and negative signals within the IPO process? (signaling theory), 7) What role do lockups serve in the IPO process?, 8) Along with several other issues in the IPO literature. To explore these issues, we designed a series of surveys, with each question carefully derived from the extant IPO literature. We administered the surveys to three subsamples of firms those that have recently and successfully completed an IPO, those that have recently attempted to go public but chose to withdraw the issue, and those firms that are large enough to go public, but prefer to stay private. By examining these distinct groups of firms through the eyes of their CFOs, we are able to draw many reassuring, and several surprising results. The remainder of the paper consists of a brief overview of the methodology in Section II. Sections III VIII, in turn, address the various issues in the IPO literature and report our survey results and interpretations of the analysis of each area. Section IX discusses and reports the survey results for why firms choose not to go public. Finally, Section X summarizes and concludes. II. Research Methodology A. Survey Methodology and Data Sources To understand phenomenon like going public more fully, unique insight can be obtained directly from the decision makers. Therefore, a survey methodology was employed. Our survey process followed Dillman s Total Design Method, which has 2

4 become the standard for conducting academic surveys. The Total Design Process seeks to maximize the response rate through a series of mailings to potential respondents. We began our survey-development process by conducting an extensive review of the extant IPO literature. From this research, we designed an initial survey. We circulated the survey to several leading academics to obtain feedback on the content of the survey. After modifying the survey in response to received input, we conducted a beta survey on a group of 15 academics and discussed the survey with several practitioners. At each step of the process, feedback was used to modify the survey. Finally, slight modifications were made to customize the surveys to the three targeted subsamples. An example of one of these final surveys is included in Appendix A. To construct our mailing lists, we obtained a list of companies that had either successfully completed an IPO (365 with valid addresses) or attempted and withdrawn an IPO (190 with valid addresses) from Security Data Company s New Issue Database (SDC) between January 2000 and December We validated the name of the CFO and the address of each firm, and made corrections when necessary, using EDGAR at For our private firm sample, we searched Dunn and Bradstreet's North American Million Dollar Database and Reference USA Database and selected the largest (1,500) non-financial private firms based upon previous year revenues. We assume firms this large could go public if they wanted to; however, they have made the conscience decision to remain private. We merged the two databases by hand to construct a comprehensive list of large private firms for which we could identify the CFO and his/her contact address. After validating CFO contact information, our mailing list of private firms reduces to 1,299 firms. 3

5 Upon completing the survey and mailing lists, we mailed three separate mailings on May 5, 2002; June 11, 2002; and September 12, Along with each sample, we included a personalized and signed cover letter, a personalized envelope (no labels), a postage-paid envelope, and a glossary of IPO terms that we constructed as a result of our beta tests (see Appendix B). In an attempt to increase our response rate, we promised to enter respondents' business cards into a $1,000 cash drawing and to provide respondents with an early copy of the results of the study. Response rates for the three mailings are reported in Table I. Overall, 336 CFOs provided usable surveys for a response rate of 18.1%. The breakdown by sub-sample is as follows: 212 not-tried (16.3%), 87 successfully completed (23.8%), and 37 withdrawn (19.5%) firms. Our overall response rate of 18% seems respectable and compares favorably to the Graham and Harvey (2001) response rate of approximately 9%, which they argue is comparable with other financial survey studies. For our publicly available data on the successful IPO sample, we download issue date, filing date, number of days in lockup, percentage of insiders shares before and after the offer, primary shares issued, secondary shares issued, offer price, lead underwriters, expenses of the offering, total assets before the offer, auditor, date founded, revenues before the offer, original price filing range, total overallotment shares, number of employees, primary exchange, underwriting fees, VC indicator, and a unit indicator from SDC. For the withdrawn sample, we collect filing date, withdrawn date, auditor, proceeds of the proposed offer, revenues prior to offer, total assets before offer, VC indicator, number of employees, amended filing range, original filing range, common equity before offer, exchange, total overallotment shares, secondary shares filed, primary shares filed, 4

6 unit indicator, and lead underwriter. We then pull the original prospectuses from EDGAR and ensure that the SDC data is correct. In addition, we fill in some data that are not reported in SDC (e.g., revenues prior to the offer). In the withdrawn sample, we make 13 corrections to the SDC database and 137 additions to the database from EDGAR. In the successful sample, we make 228 corrections and 36 additions to the SDC download. For returns data for the publicly traded firms, we use the University of Chicago's Center for Research in Securities Prices (CRSP) database for daily returns. For firms that do not have a long enough return stream because they went public in 2002 (at current writing, the 2003 CRSP database is not available), we extract daily prices from finance.yahoo.com. We use these same data sources for our benchmark firms when computing the long-run abnormal returns for the successful IPOs. We also use the Compustat quarterly files to extract book values for the successful firms when we match the IPO firms with benchmark firms based on market-to-book equity. 1 For the privately held firms, we draw the number of employees, the Standard Industrial Code (SIC), the firm s auditor, the firm s main bank, and revenues from Dunn and Bradstreet and Reference USA. B. Potential Weaknesses of the Survey Method Whereas the survey method provides insight directly from decision makers, it does have certain inherent weaknesses. For example, we survey CFOs of firms as proxies for the insiders that are in control at the time of the IPO. Doing so raises at least two concerns. First, is the CFO answering the CFO who was involved during the IPO decision? We are careful to send the surveys to the CFOs as reported on the offering prospectuses archived at the SEC and survey over a relatively short window after the IPO 1 When common equity is not available on the Compustat quarterly files (or older than the annual data), we use the annual Compustat file. 5

7 (1-3 years). Second, does the CFO represent insiders who make the decision to go public or not. We purposely target the CFO because we feel of all of the officers, the CFO is in the position to fully understand the financial motivations and ramifications of going public (as well as the actual process). Since our questions are driven by theories from the financial literature, we thought the CFO was the key informant best positioned to provide valid and reliable information. Additionally, CFOs are generally high-ranking officers within the company and may own stock or stock options. Perhaps subsequent studies of a survey nature may survey other insiders, such as the Chairman of the Board, the CEO, or the largest blockholder. We acknowledge that having the input of all of these insiders may add valuable information to our understanding of the IPO process. We feel confident however, that our choice of surveying the CFO is logically consistent with our research intent and with accepted academic practice (e.g., Graham and Harvey (2001), Pinegar and Wilbricht (1989), and Trahan and Gitman (1995)). Another potential weakness concerns the years surveyed. We targeted firms over the three years Most of this period immediately follows the bursting of the internet bubble. CFOs during our surveyed period of time may not hold the same perceptions as they did during the roaring IPO years of 1998 and Inasmuch as the theories explaining IPO behavior do not vary over time or market conditions, our findings should generalize. However, if these theories are time or market dependent, then our findings may only apply to scenarios where similar market conditions exist 6

8 III. Why go public? A. Academic Theory of Motives for Going Public The existing literature is not quiet in addressing this issue; however, the empirical literature has been hampered by a lack of data. Empirically, only Pagano, Panetta, and Zingales (1998) are able to directly test for factors that contribute to a firm s decision to go public by using a proprietary database of private Italian firms and comparing it to public Italian firms. In a less direct approach, Brau, Francis, and Kohers (2003) compare firms that choose to conduct an IPO versus private firms that choose to be acquired by a public firm. By constructing our database via the survey method, we are able to directly test the existing theories on why firms choose to go public. Drawing from the cost of capital literature (e.g., Scott (1976) and M&M (1963)), it is reasonable to argue that firms conduct a public offering, when the external equity will minimize their cost of capital. In a discounted valuation framework, the decreased cost of capital will increase the present value of future cash flows and hence the value of the company. Closely related to the cost of capital line of reasoning, Myers and Majluf (1984) and Myers (1984) argue for a pecking order of financing. They assert that firms will rely on financing in the order of cost beginning with internal equity, proceeding to debt financing, and then finally to external equity when other cheaper sources of financing have dried up. Several theories suggest that IPOs facilitate the cashing-out of insiders. For example, Zingales (1995) and Mello and Parsons (1998) argue that an IPO creates a public market for the firm s shares so shareholders can convert to cash at a later date. Ang and Brau (2003) demonstrate that sometimes insiders sell personal shares in the IPO for 7

9 personal gain in a partial cash-out. Additionally, Black and Gilson (1998) argue that the IPO gives VCs the opportunity to exit and provides an attractive harvest strategy. A couple articles argue an IPO facilitates merger and acquisition activity. Zingales (1995) argues that an IPO can serve as a first step in having a company taken over at an attractive price. Brau, Francis, and Kohers (2003) suggest that IPOs may be important because they create public shares for a firm which may be used as a currency in either acquiring other companies or in being acquired in a stock deal. The last camp of theories suggests strategic reasons for IPOs. Chemmanur and Fulghieri (1999) argue that IPOs serve to broaden the base of ownership of the firm. Maksimovic and Pichler (2001) argue that firms may conduct an IPO to capture a firstmover advantage. They also suggest that an IPO can increase the publicity or reputation of the firm going public. Finally, Bradley, Jordan, and Ritter (2003) show that analyst recommendations are often biased upward after an IPO. Following this observation, an analyst following may motivate some firms to conduct an IPO. B. Survey Results and Empirical Evidence on Why Firms Go Public. The CFOs were asked to indicate on a 5-point scale, How important were/are the following motivations for conducting an IPO? The survey results are reported in Table II. In the table we first report the mean, rank and the percentage of respondents that agree (i.e., respond 4 or 5 on a five point scale where 5 is strongly agree) for the overall sample. We have analyzed medians, standard deviations, full frequency distributions, and Chisquare tests for each question. For the sake of brevity, we do not include all of these statistics; however, they are available upon request. 8

10 The control variables in Table II are included in all of the subsequent tables. We will briefly describe each of the column headers here. Overall represents the combined sample. IPO Status includes a column for the withdrawn, successful, and not tried samples. Size is based on total revenues with firms having revenues over $100,000,000 considered large and those with less classified as small. We partition employees at 500, the Small Business Administration cutoff for a small firm. For age, we divide at the closest year to the median, greater than 1985 considered young. For the underwriter prestige metric, we use the data provided by Jay Ritter on his website and we define high prestige underwriters as having a rank of 8.1 or greater. Venture Capital is an indicator variable that equals one when an IPO has VC backing and zero otherwise. Ownership Decrease represents the decrease in insider (manager) shareholdings in the IPO. We cut at the median, a 23% decrease. Secondary shares is an indicator variable that equals one if secondary shares were sold in the IPO and zero otherwise. Following Bradley and Jordan (2002), overhang is defined as the quantity of shares outstanding prior to the offer minus the number of secondary shares all divided by the total shares offered in the IPO. We classify low and high overhang divided at the median. Integer offer price is an indicator variable that equals one if the IPO's final offer price is an integer and zero otherwise (see Bradley, Cooney, Jordan, and Singh (2004). We classify IPO Demand as high if the final offer price is above or equal to the original mid-filing price and low otherwise. We compute the initial return as the percent return from the offer price to the first closing price on CRSP. We follow Krigman, Shaw, and Womack (1999) and define a cold IPO as one having an initial return of less than 10 percent and a hot IPO as otherwise. Finally, we follow the methodology of Barber, Lyon, and Tsai (1999) to compute the one-year 9

11 abnormal return and classify positive (negative) IPOs as those having one-year abnormal returns greater or equal to (less than) zero. The first row of Table II, somewhat surprisingly indicates that overall, CFOs feel most strongly that an IPO serves to create public shares for use in future acquisitions. They view public shares serve as a form of currency. This finding supports the assertions of Zingales (1995) and the empirical findings of Brau, et. al (2003). The mean score for this question is 3.56, with nearly 60% of the CFOs agreeing that creating public shares for future acquisitions is an important motivation for conducting an IPO. The three subsamples also rank this motivation high the withdrawn sample ranks it first and the successful and not-tried samples rank it second. For each of the subsample survey question responses, we conduct Tukey and Bonferonni simultaneous difference tests to determine if the various subsamples responded significantly differently. In the case of the first question, the withdrawn sample (mean = 4.00) is significantly greater than the nottried sample (mean = 3.37). It is interesting to note that CFOs at smaller firms and firms established since 1985 take a more aggressive view regarding the use of public shares in future acquisitions. Finally, CFOs at companies where secondary shares are offered demonstrate a much lower (p=.05) level of interest in using public shares for future acquisitions. The fact that they are issuing secondary shares reveals a greater interest in maximizing immediate returns and a leaning toward cashing out. The second row of Table II indicates that overall, CFOs feel the establishment of market price or value of the firm ranks second in importance. The difference tests indicate that the withdrawn and successful samples both significantly differ from the not-tried sample. CFOs at companies that have decided to remain private do not appear to be 10

12 worried about their companies perceived market value. We found that through most of the survey questions, those CFOs that attempted an IPO (whether they were successful or not) often disagreed with those CFOs who have decided not to attempt an IPO. Inasmuch as theories should be robust to all rational decision-makers, we find this result of interest. One explanation for this difference may be that rational not-tried CFOs choose to work for firms that are better off not going public. Thus by self-selection, these insiders rationally feel different about the IPO process than those CFOs who attempt to go public due to the unique characteristics of their firms. An alternative explanation relies on the notion of behavioral finance and that perhaps CFOs do not always act in the rational expectations paradigm, instead acting instead according to psychology theory. A final point of interest concerns the relatively low scores related to cost-of-capital motivations. With a mean of 3.12, the desire to minimize the cost of capital ranked fourth among the CFOs behind the use of public shares as a currency, establishing a market price for the firm, and enhancing the reputation of the firm. Fewer than half of the CFOs viewed the goal of minimizing the cost of capital as an important rationale for going public. The other two questions that pertain to the role of using equity to finance operations our company has run out of equity and debt is becoming too expensive were viewed as the two least important reasons for going public. Perhaps the existence of low interest rates at the time of the data collection reduced the motivation to go public as a means of financing operations and growth. It is also possible that CFOs perceptions have indeed changed. It appears that IPOs are now viewed less as a source of operating capital than as a source of wealth, which can be employed more strategically. That is, strategic 11

13 motivations for going public such as enhancing firm reputation and broadening the base of ownership are seen as more important than acquiring additional capital. The detail analysis of the remainder of Table II will be left to the reader. Generally however, it is interesting that only the top two explanations receive a majority vote of agreement from the overall CFO sample. Overall, Further, those CFOs who have attempted to go public significantly disagree about the importance of going public to enhance the reputation of the company and the importance of attracting analysts attention. In both cases those who have tried to go public feel these motivations are more important than those CFOs who have not tried to go public. To summarize, of the top eight ranked questions, only one actually directly impacts the operations of the firm by lowering the cost of capital and potentially decreasing investment hurdle rates. The creation of public shares may also indirectly impact operations, by impacting the cost of capital. With these exceptions, it appears the primary motives for IPOs are more of a positioning or marketing strategy than an operational step. IV. What factors determine the timing of going public? A. Theories Pertaining to the Timing of IPOs One of the persistent areas of interest in the IPO literature is the "hotness" of the IPO in the aggregate and the timing of IPOs by individual firms. From the early work of Ibbotson and Jaffe (1975) and Ritter (1980) to the present-day literature, it has been documented that IPOs tend to come in waves as measured by both volume and the degree of underpricing. In this section, we discuss the extant theories that have been advanced to explain the timing of IPOs. 12

14 The first line of theories deal with the current overall market conditions (Lucas and McDonald (1990)), the current industry conditions (Pagano, Panetta, and Zingales (1998)), the predicted overall market conditions (Lucas and McDonald (1990)), the predicted industry conditions (Lowery, 2002), and recent historical market conditions (Ritter and Welch (2002)). The central idea behind these theories is that when the overall market or industry is doing well, firms will tend to take advantage of the prosperous times and issue in an attempt to earn attractive stock prices. A second line of theories specifically targets the IPO market. Lowery and Schwert (2002) argue that the recent first-day stock performance of firms going public positively influences other firms to decide to go public. Choe, Masulis, and Nanda (1999) argue that firms prefer to go public when other good firms are currently issuing. The final two theories we address in our survey follow from the work of Choe, Masulis, and Nanda (1999) and Lowery (2002). Choe, et al. argue that firms will go public when they reach a certain point in the business growth cycle and need the capital to continue to grow. Other than the business growth cycle explanation, all of the other explanations generally fit in the window of opportunity hypothesis of Ritter (1991) and Loughran and Ritter (1995). Generally, firms time their IPOs to take advantage of favorable windows in time that will allow them to get the most attractive offering prices and highest valuations of their companies. B. Survey results/empirical evidence on timing of IPOs. The CFOs were asked to indicate on a 5-point scale (1=not important; 5=very important), To what extent do the following influence the timing of a possible IPO? Table III reports the CFO replies. Overall stock market conditions were identified as the 13

15 single most important determinant of timing (mean=4.21, %4-5=83). This finding was consistent regardless of how the sample was partitioned. Two other factors were also perceived as affecting the timing of an IPO: industry conditions (3.87) and the need for capital to support growth (3.82). In both instances, slightly more than two-thirds of the CFOs indicated agreement that these issues are important. The final two issues other good firms currently going public and first-day stock performance of recent IPOs were viewed as relatively unimportant. Fewer than one in four CFOs attributed importance to these two factors. To summarize, the data suggest that CFOs do pursue windows of opportunity, but they define these windows in terms of overall stock market and industry conditions. They are much less influenced by decisions being made at other companies. The theory that companies go public when they need the capital to finance growth is also supported. Two other themes also emerge from the data presented in Table III. First, the inclusion of venture capitalists in the IPO process raises managerial awareness of each timing factor. For four of the five factors, the increase in influence on the timing of an IPO is statistically significant at the p=.05 level or greater. Obtaining funding from venture capitalists increases the opportunistic perspectives of CFOs. There is also an increased emphasis on the pursuit of growth. Managers need to recognize these realities as they seek funding for their businesses. Second, looking at the partition by ownership decrease suggests CFOs at large-decrease companies are less concerned with windows of opportunities. However, their emphasis on going public to pursue growth appears to increase. 14

16 V. Underwriter reputation/selection in IPOs. A. IPO Lead Underwriter Selection In this section, we base our questions on the selection of a lead underwriter from Krigman, Shaw, and Womack (2001). In an article that addresses the question why firms switch investment banks between the IPO and a follow-on secondary equity offering (SEO), they survey CFOs and ask them to rank from a list of reasons, the importance of why they chose their IPO underwriter. We ask the same questions with the addition of one that pertains to IPO spinning at the suggestion of Jay Ritter. We use the identical questions from Krigman, et. al for three reasons. First, it allows us to compare our larger sample of CFO responses with their sample of CFO responses. (Our sample dates do not overlap, so it is highly unlikely that we have repeated CFOs in our two samples.) By comparing our sample replies to those of Krigman et al.'s, we are able to measure the level of consistency in this one question in a pre-bull ( ) period to our sample that is conducted in a post-bull period ( ). Second, by using a 5-point scale to assess the importance of each criterion, it is possible to determine both absolute and relative importance of the criteria used to select a lead IPO underwriter. Finally, we also are able to have CFOs of firms in three different positions (successful IPOs, withdrawn IPOs, and not-tried IPOs) provide data as opposed to Krigman, et al., who only surveyed firms that successfully conducted an IPO. B. Empirical Evidence on the Selection of Lead IPO Underwriters The CFOs were asked to indicate on a 5-point scale (1=not important; 5=very important), How important are the following criteria in selecting a lead IPO underwriter? The CFO responses are reported in Table IV. Interestingly, only three 15

17 criteria received mean scores greater than 4.0: overall reputation (mean=4.39, %4-5=91), quality of research (4.25, 83%), and industry expertise (4.24, 88%). Each of these mostimportant criteria focuses on the reputation and expertise of the underwriter. Clearly, the principal intermediary role (i.e., the ability to provide the expertise needed to carry out a successful IPO) represents the most important issue in selecting an underwriter. Three other selection criteria received mean scores greater than 3.0, indicating that they are viewed as somewhat important in screening potential underwriters. Approximately half of the CFOs place substantial weight on an underwriter s market making and trading desk services, suggesting that post-ipo trading is an important consideration in the up-front selection of an underwriter. Similarly, about half of the CFOs carefully evaluate the institutional client base of the underwriter. The quality of the institutional client base provides a secondary measure of the underwriter s prestige and promotes future tradability of the stock. Finally, slightly fewer than half of the CFOs are influenced by pricing and valuation promises. Most CFOs appear to believe that if a capable and reputable underwriter is selected, the stock valuation/pricing will fall in a reasonable and acceptable range. It is important to note that the relative importance of selection criteria is consistent with Krigman, et al. s (2001) findings. Several other points merit brief attention. For example, companies that have attempted to go public (either successfully or unsuccessfully) view the underwriter selection process differently than companies that have remained private. They place more emphasis on the underwriter s research capability while paying less attention to valuation promises and fee structure. Interestingly, companies that have venture capital backing appear to place greater weight on underwriter reputation and expertise. Additionally, high 16

18 overhang companies likewise give an elevated credence to underwriter reputation and expertise. Finally, CFOs at companies that selected high prestige underwriters place greater emphasis on underwriter reputation as well as the services provided by the underwriter. They are also less concerned with valuation promises and fee structure than their counterparts. For many CFOs, the high-prestige designation appears to be a surrogate for an extensive underwriter selection process. VI. Underpricing in IPOs A. Theories of Why Underpricing Exists Perhaps the most widely known facet of IPO security behavior is that of underpricing. On average, firms that conduct an IPO leave extra money on the table because the price that the firm's shares are offered to the public is below what the market is willing to pay for the shares, as evidenced by first-day closing prices. The topic of underpricing has been the focal point of many financial economic papers. In this section, we will briefly (and chronologically) list some of the leading reasons advanced for the existence of underpricing. For a more detailed survey, we would direct the reader to Ibbotson and Ritter (1995). Baron and Holmstrom (1980) and Baron (1982) argue that underwriters exploit their superior knowledge of the market and underprice issues to minimize marketing effort and to ingratiate themselves with buy-side clients. Beatty and Ritter (1986) argue that underpricing exists due to the non-transparency or uncertainty about the private firm which chooses to go public. That is, because firms are not transparent and there is a lot of uncertainty surrounding the valuation of the IPO, offering prices are generally biased under unknown future market price. Rock (1986) also argues that the uncertainty or risk 17

19 of the IPO drives underpricing and that uninformed investors must be compensated for taking the risk of the IPO. Benveniste and Spindt (1989), Benveniste and Wilhelm (1990), and Spatt and Srivastava (1991) argue that underpricing is a reward to sophisticated investors for divulging accurate valuation information during the book-building process. Tinic (1988), Hughes and Thakor (1992), and Drake and Vetsuypens, 1993 advance the idea that underpricing serves as a protection against possible future litigation from investors. Welch (1992) models the idea that underpricing can cause a domino or cascade effect among investors that ultimately raises the demand for the issue. Booth and Chua (1996) argue that underpricing helps ensure a wide-base of owners to increase the liquidity of the newly public firm. Along similar lines, Brennan and Franks (1997) agree that underpricing allows for a wide-base of owners but argue the motivation is to entrench management. Siconolfi (1997) suggests that underpricing permits the practice of spinning, the enriching of executives of prospective investment bank clients. Stoughton and Zechner (1998) argue underpricing allows for the creation of a blockholder that can increase monitoring. Along similar lines of Siconolfi (1997), Aggarwal, (2002), Fishe (2002), and Krigman, Shaw, Womack (1999) argue that underpricing allows for the practice of flipping by favored investors. Pulliam and Smith (2000, 2001) assert that underpricing allows underwriters to receive quid pro quos from buy-side clients. Habib and Ljungqvist (2001) argue underpricing allows for cost savings in other areas of marketing the issue. Boehmer and Fishe (2001) demonstrate that underpricing increases the after-issue trading volume of the 18

20 stock. Ljungqvist and Wilhelm (2002) argue that underpricing enriches friends and family through directed share programs. Loughran and Ritter (2002) advance a behavior theory that issuers are pleasantly surprised with the amount they can raise in the IPO and are not significantly concerned with the underpricing. Finally, Demers and Lewellen (2003) argue underpricing brings attention to the stock on the opening day. B. Empirical Evidence on Underpricing To better understand the nature of underpricing, two issues were examined. Initially, to define the extent of underpricing that insiders expect, CFOs were asked to indicate the percent underpricing they would expect from the offer price to the first day closing price. The median expected underpricing was 10 percent. This compares to an actual median underpricing of 13.5 percent for the companies that successfully completed an IPO. After accounting for a couple of outliers, it appears that CFOs are well-informed regarding underpricing expectations. More importantly, to explore the reasons underpricing is prevalent, the CFOs were asked to indicate on a 5-point scale, To what extent do the following lead to the level of underpricing you expect(ed)? Table V reports the CFO perceptions. Only one rational received majority support from the CFOs to compensate investors for taking the risk of the IPO (mean=3.47, %4-5=59.5). Three other rational achieved mean scores above 3.0: underwriters underprice to incur the favor of institutional investors (3.20, 42%), underpricing ensures a wide base of owners (3.17, 41%), and underpricing increases afterissue trading volume (3.14, 43%). Of these, only the underprcing to incur the favor of institutional investors appears to be an intentional effort on the part of underwriters to profit from underprcing. Overall, market uncertainty and the lack of perfect information is 19

21 thus perceived to be the most influential reason underpricing exists. The low scores for flipping, reducing IPO marketing costs, and spinning suggest that CFOs place a high degree of confidence in their underwriters and the underwriting process. It is interesting to note that CFOs at companies that have never initiated the IPO process are somewhat more skeptical than those who have attempted an IPO. They place relatively more weight on a variety of issues suggesting that underpricing is intentional rather than a function of risk and uncertainty. VII. Signaling in IPOs A. Extant Signaling Theories Signaling literature continues to be an important component of IPO research. Early papers, such as Leland and Pyle (1977) modeled and argued that selling insider shares and selling a large portion of the firm in the IPO served as negative signals to potential investors. Since that time, other researchers have used the setting of IPOs to advance signaling theory. Within signaling theory is the idea of certification. Generally, using prestigious underwriters (e.g., Booth and Smith (1986) and Carter and Manaster (1990)), using a reputable accounting firm (e.g., Titman and Trueman (1986) and Beatty (1989)), and having VC-backing (e.g., Megginson and Weiss (1991)) serve as strong signals or certification that the firm going public is a good firm. Three other positive signals advanced by the extant literature are that 1) only good firms can afford to dissipate wealth by underpricing (Welch (1989), Allen and Faulhaber (1989) and Chemmanur (1993)); 2) a history of strong earnings signals future strong performance (e.g., Teoh, Welch, Wang (1998)); and 3) insiders who commit to a long 20

22 lockup period signal the firm is a good firm (Courteau (1995) and Brau, Lambson, and McQueen, 2003) B. Empirical survey results. To gain insight into the nature of signaling, the CFOs were asked to indicate on a 5-point scale (1=negative signal, 5=positive signal), What type of signal do the following actions convey to investors regarding the value of a firm going public? The data in Table VI identify six behaviors as positive signals regarding the quality of an investment in an IPO. The single most important positive signal is for a company to have strong historical earnings. Logically, past success is viewed as the best indicator of future returns. Certification, or working with high-profile partners, is also perceived as a positive signal. The most important partner is a prestigious investment banker (mean=4.21, %4-5=89), followed by the use of a big-4 accounting firm (3.91, 74%), and the backing of a venture capital firm (3.24, 40%). Thus, mangers interested in conveying a positive signal should pursue a prestigious underwriter and utilize a high-profile accounting firm. The final two positive signals are 1) insiders commit to a long lockup and 2) a large first-day stock price jump. Both of these indicators suggest that people are confident in the company s longerterm performance. That is, a willingness of insiders to agree to a long-term lockup suggests that they are not in a hurry to cash out; rather, they are committed to the company s longer-term success. A large first-day stock price jump denotes that outside investors are confident in the company s future. Three behaviors were identified as negative signals: selling a large portion of the firm in the IPO, issuing units, and selling insider shares in the IPO. The primary message conveyed through these behaviors is a lack of confidence in the company. Insiders appear 21

23 to be cashing out. To summarize, behaviors that denote confidence in a company s future are viewed as positive signals while behaviors that raise questions about insiders confidence are perceived negatively. VIII. Miscellaneous IPO Issues A. Lockup, Greenshoe, Underwriting Type, Unit Offering, and Window-dressing In this section, we address several IPO topics that historically have not generated a voluminous literature. We combine them in one section for brevity. In recent IPO literature, the lockup period has received considerable attention (e.g., Field and Hanka (2002), Brav and Gompers (2002), Brau, Lambson, and McQueen (2003)). Brav and Gompers argue that the lockup period serves to align management with future stockholders for the lockup duration (normally 180 days). Courteau (1995) and Brau, Lambson, and McQueen (2003) model and argue that lockups rather serve as signaling devices. Aggarwal (2000) and Zhang (2001) study the overallotment (Greenshoe) provision. When a firm goes public, it has the choice to conduct a firm commitment offer versus a best-efforts offer. In a firm commitment offer, the underwriter serves as a dealer, taking a personal inventory of all of the shares and then reselling. In a best-efforts deal, the underwriter serves as a broker, never taking a personal position. Various authors have examined the choice of underwriting contract (e.g., Mandelker and Raviv (1977), Ritter (1987), Sherman (1992), Cho (1992), and Welch (1991). The last two areas of interest in this section are the impact of a unit offering and the role of window-dressing. Barry, Muscarella, and Vetsuypens (1991), Chemmanur and Fulghieri (1997), and Schultz (1993) all study unit offerings an offering in which 22

24 warrants are attached to the shares of stock at issuance. Finally, Teoh, Welch, and Wang (1998) analyze window-dressing in the IPO prospectus. B. Discussion of Survey Results To gain insight into the issues identified above, the CFOs were asked to indicate on a 5-point scale (1=not important, 5=very important), From your perspective, how important are the following IPO process issues? Their perceptions are reported in Table VII. CFOs clearly favor a firm commitment underwriting (mean=3.93, %4-5=72) over a best-efforts underwriting. The fact that an underwriter takes a personal stake in the IPO enhances the confidence the CFO feels in both the underwriter and the IPO process. Similarly, CFOs view the lockup period as an important mechanism to align management with future stockholders (3.58, 64%). CFOs also view the overallotment option as somewhat important; however, the data (mean=3.3; %4-5=44) suggest that the overallotment option really is not a major interest or concern. Finally, CFOs do not perceive window-dressing or unit offerings as important issues. Perhaps more interesting than the overall findings are the comparative perceptions between the CFOs at companies that tried but withdrew an IPO and the CFOs at companies that successfully completed an IPO. CFOs at the withdrawn companies view each of these issues as more important than their counterparts. Each of these issues can introduce ambiguity and uncertainty into the IPO process, increasing the risk and cost of going public. CFOs at firms that attempted but withdrew an IPO are thus much more sensitive to these issues. 23

25 IX. Why Don't Firms go Public? In this final section motivating the survey questions, we asked CFOs how important certain factors were in a) their decision not to conduct an IPO (not-tried sample), b) their decision to withdraw their IPO (withdrawn sample), or c) how much each of the factors concerned them in the IPO process (successful sample). For these survey questions, we abstracted from the literature that addresses why firms may not want to go public and from the rational in the popular press. Again, for brevity we will not motivate each question as reported in Appendix A, instead we will proceed immediately to the interpretation of the survey results. The previous sections have all addressed issues related to the process of going public. Many firms, however, including a large portion of our sample have made the deliberate decision to remain private. To understand why, we asked the CFOs to answer a variant (see previous paragraph) of the following question, To what extent have the following influenced your decision NOT to conduct an IPO? A 5-point scale (1=no influence, 5=great influence) was used. The CFOs responses are reported in Table VIII. The overall results suggest that maintaining control is the most important (mean=3.48, %4-5=56) issue in deciding whether or not to go public. Two other issues received mean scores above 3.0: to avoid ownership dilution and bad market/industry conditions. These findings are not unexpected. Perhaps of greater interest is the fact that when partitioned based on IPO status, CFOs view this issue significantly differently. Focusing initially on the never-tried subsample, reveals that two issues dominate the thinking of insiders in this group: the desire to maintain decision-making control and the desire to avoid ownership dilution. These 24

26 are the only two scores above 3.0. These CFOs are single minded; that is, there is no overriding issue that leads these insiders to seriously consider going public and risking the loss of control. For now, they are generally satisfied that they have enough capital to finance operations and growth (mean=2.97) and are not interested in going public. The CFOs from the successfully completed IPO companies share a different story. Their biggest concern as they approach going public was the state of the market/industry. However, the reported mean of 3.17 does not represent a sufficient concern to keep them form going public. Two other issues that raised some concern were 1) the risk of disclosing information to competitors (3.06) and 2) the desire to maintain decisionmaking control. The fact that the companies did proceed with a public offering is evidence that the decision makers felt these issues could be managed successfully. No other issue scored above 2.86 (the cost/fees of an IPO). Finally, the CFOs at companies that started and then withdrew from the IPO process are motivated by two timing issues bad market/industry conditions (4.76) and a low stock price (3.36). The next highest score pertains to already having sufficient capital and is a relatively small Thus, perceptions vary depending on IPO status. X. Summary and Conclusion Based on the insight gleaned from the CFO respondents, academic theory regarding the IPO process is generally well grounded. However, the CFO perceptions suggest a need to revisit and refine several ideas that are commonly held in the IPO literature. Among the most important findings discussed in this research are the following: 25

27 The most important motivation for going public in today s marketplace is to create public shares for use in future acquisitions. Minimizing the cost of capital is not among the three most important motivations for going public. Insiders are opportunistic, seeking to go public at a time that portends a high stock price. CFOs define the window of opportunity in terms of overall stock market and industry conditions. The underwriter selection process is driven by a very small set of selection criteria that focus on the underwriter s reputation and IPO process expertise. CFOs are well-informed regarding expected underpricing. They perceive the IPO process to be generally rational, attributing most underpricing to market uncertainty and the need to reward investors for taking the risk of the IPO. CFOs report little concern that underwriters are gaming the IPO process for their own benefit. The most important positive signal is past historical earnings. However, CFOs view a variety of behaviors that convey insider confidence in the company s future as positive signals. They also perceive certification to be a positive signal. Behaviors that suggest insiders are anxious to cash out are perceived as negative signals. CFOs are generally comfortable with the IPO process. They do however strongly prefer firm commitment underwriting and the standard 180 lockup period. CFOs at firms that have withdrawn IPOs are statistically more concerned with the uncertainty and costs associated with the IPO process. Companies remain private to preserve decision-making control and ownership. However, IPO status strongly influences CFO perceptions regarding the risks and difficulties encountered in going public. Ultimately, the IPO process is fairly well understood and rationally managed. The decision and the timing to go public depends heavily on the tradeoff between control and opportunity for return. Private companies have not found the potential financial returns large enough to pursue an IPO. By contrast, firms that have successfully gone public have identified the opportunity, weighed the costs, and worked with credible intermediaries to manage the process in an appropriate and timely manner. They report that the barriers to going public are manageable and appear to be satisfied with the outcome. Finally, CFOs at companies that withdrew from the IPO process indicate that 26

28 they were anxious to go public until market conditions changed, reducing the return and the desire to proceed. 27

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