Lockup Agreements
• Not legally required but common
• Restricts insiders from selling IPO shares for a specified time period
– Common lockup period = 180 days
• Stock price tends to drop when the lockup period expires due to market anticipation of additional shares hitting the Street
The lockup agreement prevents insiders from selling their shares for some period after the IPO, usually 180
days. The stock price often drops right before the lockup period expires in anticipation of a large number
of shares flooding the market (excess supply causes the price to drop). This is the time that venture
capitalists and other early-stage investors will be able to exercise their “exit” strategy.
Such agreements specify how long insiders must wait after an IPO before they can sell some or all of their
stock.
The Quiet Period – The quiet period is a period of time around the IPO when company employees and the
underwriters must limit communications with the public to “ordinary announcements and other purely
factual matters.” This is done to prevent too much hype in the hope of increasing demand for the stock.
Slide 15
15-15
IPO Underpricing • IPO underpricing: a large increase above the offer price the
first day of trading
• IPO pricing may be difficult to price an IPO because there isn’t a current market price available – Private companies tend to have more asymmetric information than
companies that are already publicly traded.
– Underwriters want to ensure that, on average, their clients earn a good return on IPOs.
• Dutch Auctions designed to eliminate first day IPO price “pop”
• Underpricing causes the issuer to “leave money on the table”
• Degree of underpricing varies over time
Determining the correct offering price is the most difficult thing an underwriter must do for an initial public
offering. The issuing firm faces a potential cost if the offering price is set too high or too low. If the issue
is priced too high, it may be unsuccessful and have to be withdrawn.
Underpricing: too low offering price < market closing price in the first day of trading
Underpricing (a large increase above the offer price the first day of trading) is fairly common. It obviously
helps new shareholders earn a higher return on the shares they buy. However, the existing shareholders of
the issuing firm are not helped by underpricing. To them, it is an indirect cost of issuing new securities.
Consider the Visa IPO. The stock opened at $44 and rose to a first-day high of $69, before closing at $56.50,
a gain of about 28 percent. Based on these numbers, Visa was underpriced by about $12.50 per share, which
means the company missed out on an additional $5.6 billion or so, the largest dollar amount “left on the
table” in history.
Such young firms can be very risky investments. Arguably, they must be significantly underpriced, on
average, just to attract investors, and this is one explanation for the underpricing phenomenon.
Furthermore, when the price is too low, the issue is often “oversubscribed.
Slide 16
15-16
IPO Underpricing
The underpricing (there is a large increase above the offer price the first day of trading) of IPOs is very
common. Empirical evidence suggests that it has gotten worse in recent years. As Table 15.2 points out,
the average underpricing has been higher from 2000 to 2007, even with a down market, than any other
period in time. The record year, though, is still 1999 with an average first day return of almost 70 percent.
How have recent IPOs performed?
Hoovers.com’s “IPO Central”
Use the “IPO Calendar” to determine how many companies went public during the last week
Slide 17
15-17
IPO Underpricing Reasons
• Underwriters want offerings to sell out
▪ Reputation for successful IPOs is critical
▪ Underpricing = insurance for underwriters
▪ Oversubscription & allotment
▪ “Winner’s Curse”
• Smaller, riskier IPOs underprice to attract investors
Why Does Underpricing Exist?
Possible explanations include:
• most are driven by smaller, speculative issues • oversubscription of issues due to a limited number of shares • investment banks need to be sure they can clear an issue • a reward to institutional investors for helping in the book building process
To illustrate, consider this tale of two investors. Smith knows very accurately what the Bonanza Corporation
is worth when its shares are offered. She is confident that the shares are underpriced. Jones knows only that
prices usually rise one month after an IPO. Armed with this information, Jones decides to buy 1,000 shares
of every IPO. Does he actually earn an abnormally high return on the initial offering?
The answer is no, and at least one reason is Smith. Knowing about the Bonanza Corporation, Smith invests
all her money in its IPO. When the issue is oversubscribed, the underwriters have to somehow allocate the
shares between Smith and Jones. The net result is that when an issue is underpriced, Jones doesn’t get to
buy as much of it as he wanted. Smith also knows that the Blue Sky Corporation IPO is overpriced. In this
case, she avoids its IPO altogether, and Jones ends up with a full 1,000 shares. To summarize this tale,
Jones gets fewer shares when more knowledgeable investors swarm to buy an underpriced issue and gets
all he wants when the smart money avoids the issue. This is an example of a “winner’s curse,” and it is
thought to be another reason why IPOs have such a large average return. When the average investor “wins”
and gets the entire allocation, it may be because those who knew better avoided the issue. Another reason
for underpricing is that the underpricing is a kind of insurance for the investment banks. Conceivably, an
investment bank could be sued successfully by angry customers if it consistently overpriced securities.
Underpricing guarantees that, at least on average, customers will come out ahead.
Ethics Note: Traditionally, IPOs have been reserved for the syndicates’ best customers, but the investment
bankers have to be careful how they allocate those shares. In July, 2004, Piper Jaffray was fined $2.4
million for selling shares of “hot” IPOs to the executives of firms that they have either recently done
business with or with whom they were trying to gain business.
Slide 18
15-18
New Equity Issues and Price
• Stock prices tend to decline when new equity
is issued
• Possible explanations for this phenomenon:
▪ Signaling explanations:
• Equity overvalued: If management believes equity is
overvalued, they would choose to issue stock shares
• Debt usage: Issuing stock may indicate firm has too
much debt and can not issue more debt
▪ Issue costs
• equity is more expensive to issue than debt
from a straight flotation cost perspective.
It seems reasonable to believe that new long-term financing is arranged by firms after positive net present
value projects are put together. As a consequence, when the announcement of external financing is made,
the firm’s market value should go up. Interestingly, this is not what happens. Stock prices tend to decline
following the announcement of a new equity issue (a seasoned equity offering).
Why? A number of researchers have studied this issue.
Much of the decline may be due to the private information known by management (called asymmetric
information) and the signals that the choice to issue equity sends to the market.
• Managerial information concerning value of the stock (Equity Overvalued) – expectation that managers will issue equity only when they believe the current price is too high
• Equity Overvalued – This will benefit existing shareholders. However, the potential new shareholders are not stupid, and they will anticipate this superior information and discount it in
lower market prices at the new-issue date.
• Debt usage – issuing equity may send a signal that management believes the company currently has too much debt.
• Issue costs – equity is more expensive to issue than debt from a straight flotation cost perspective
Since the drop in price can be significant, and much of the drop may be attributable to negative signals, it
is important for management to understand the signals that are being sent and try to reduce the effect when
possible.