The CFO's Perspective On How Real-Time Practice Relates To Common IPO Theories

Thursday, June 15, 2006

Prof. James Brau and Prof. Stanley Fawcett, Marriott School, Brigham Young University, http://

Abstracted from: Initial Public Offerings:
An Analysis Of Theory And Practice
Journal of Finance - Vol. 61, No. 1, Pgs. 399-436

The top reason to go public.
Theorists offer many rationales for taking a company public. It increases liquidity and reduces the cost of capital. It may allow the founder and other insiders to diversify their personal finances or even exit the business entirely. A successful IPO brings positive publicity and analyst coverage, which can enhance the company's reputation and thus improve business. Yet when business professors James Brau and Stanley Fawcett asked 336 CFOs, the most important reason the executives gave is to facilitate acquisitions, because stock can raise cash and serve as currency in mergers. Being listed can lead to becoming a target as well as an acquiror. Nevertheless, newly public companies engaging in M&A much more often buy others (88%) rather than become targets themselves (12%), and stock financing plays a role in most of the deals. For the more speculative company, such as a high-tech startup, the external validation of having achieved sufficient stature to go public is of particular value.

Comparing theory to practice.
The authors used the survey data to compare other IPO theories­including underpricing, timing, signaling, and selecting underwriters­with real-time practice. For example, most analysts believe that asymmetric information leads to underpricing, theorizing that investors know less about previously private companies than they do about already public ones and that this lack of information makes IPO investing inherently risky. Other theories suggest that underpricing generates free publicity or ensures a reward for early shareholders to discourage them from criticizing the company or litigating over disappointments. While CFOs who have never participated in an IPO are more dubious about the value of underpricing, experienced CFOs accept that a first-day jump in share price signals a successful IPO. Survey participants overwhelmingly felt that underpricing fairly rewards investors for their risk. Analysts often see IPO activity in terms of waves, but CFOs of companies going public look at market conditions and business trends in their own industry to determine when to list. The analysts are considering IPO activity collectively; the CFOs are focusing on the particulars of their industry and the stock market in general.

IPOs can signal success.
Signaling is another theory and practice tested by the authors. Both the information revealed during the IPO process and the process itself affect the company's reputation. According to the CFOs, the most positive signal they can send the markets is a strong earnings history; the next is the selection of a top investment bank to take the company public. Hiring a top firm indicates both the ability to pay its fees and the ability to attract its high-quality investors. Other signals the CFOs believe favorable are obtaining firm-commitment underwriting; using a top-shelf accounting firm; and insiders committing to a long lockup (which shows investors that they believe in the company and are not just trying to create an exit strategy for themselves). A large first-day increase in price indicates the market's confirmation of the company's worth. The presence of earlier venture backing confirms that previous investors also found the company meritorious. On the negative side, nothing is worse from a PR point of view than unloading a lot of insider shares in the IPO or selling a high percentage of the company. Issuing units (i.e., attaching options to the stock being offered) tells investors that the shares themselves cannot carry the issue.

Abstracted from Journal of Finance
published by American Finance Association
Haas School of Business
University of California, Berkeley, CA 94729

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