Stock Offerings and Investor Monitoring: IPOs, Exchanges, and Corporate Governance

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2

Chapter 10 moves from debt markets to equity markets. This is about how companies sell ownership to the public, how stock exchanges work, and how investors try to keep corporate managers honest. If the previous chapters were about lending money, this one is about buying a piece of a company.

Private Equity: Before Going Public

Most companies start with the founders putting in their own money. That is private equity. The firm is privately held, owners cannot sell shares to the public, and growth is limited to retained earnings and bank loans.

When a firm outgrows its private funding but is not ready to go public, it might turn to a venture capital (VC) fund. VC funds pool money from wealthy investors and pension funds who are willing to lock up their capital for 5 to 10 years. Apple, Microsoft, and Oracle all received VC funding early on.

VC funds typically plan to exit within 4 to 7 years, either when the company goes public or gets acquired. They do not just hand over cash and wait. They serve as advisors, demand board seats, and provide funding in stages tied to financial goals. Most proposals get rejected because most startups fail.

Private equity funds are different from VC funds. They buy existing companies (often underperforming ones), restructure them, and sell at a profit years later. They rely heavily on borrowed money to finance acquisitions. Critics say they destroy companies by laying off employees. Supporters say the companies they target were already inefficient.

Both VC and private equity funds perform better when stock prices are generally low because they can buy in at better valuations. When too much money floods into these funds, they compete with each other, overpay for companies, and earn worse returns.

Going Public: The IPO

An initial public offering (IPO) is when a company first sells shares to the public. A typical IPO is for at least $50 million because anything smaller would not support enough trading activity in the secondary market.

The Process

The company hires a lead underwriter (a securities firm) to guide the IPO. Together they develop a prospectus, a detailed document covering the firm’s operations, financials, and risks. This gets filed with the SEC. Once approved, the company does a road show, traveling to present to institutional investors.

The underwriter uses bookbuilding to gauge demand. They ask institutional investors how many shares they would want at various prices. Based on this feedback, they set the offer price.

This is where things get interesting. The underwriter usually sets the price conservatively to make sure all shares sell. If a company could have sold shares at $13 but the underwriter priced them at $11, the company “left money on the table.” Madura presents an example where this costs the issuing firm $8 million. Some critics argue that the low pricing is a way for underwriters to do favors for their institutional clients.

Transaction costs run about 7 percent of funds raised. Add in legal fees, financial advisors, and prospectus preparation, and total costs approach 10 percent. Going public is not cheap.

After the IPO

Underwriters try to keep prices stable by purchasing shares in the secondary market if selling pressure builds. Lockup provisions prevent founders and VC funds from selling their shares for six months. But when the lockup expires, the flood of shares hitting the market often pushes prices down.

IPOs tend to cluster during bull markets when stock valuations are high. After the credit crisis began in 2008, many companies postponed their IPOs because they would not get good prices.

First-Day Returns and Flipping

The average first-day return on U.S. IPOs has been about 20 percent over the last 30 years. During the dot-com era, Internet IPOs averaged 84 percent first-day returns in 1998. That attracted flippers, investors who buy at the offer price and sell the same day. Underwriters try to discourage flipping by rewarding long-term holders with priority access to future IPOs.

But here is the reality check: many IPOs perform poorly over the long term. Firms may exaggerate their financials before the offering. Managers may waste the IPO proceeds. Investors may have been irrationally optimistic. Studies consistently show that IPOs underperform over a year or more.

Google and Facebook: Two Case Studies

Google (2004) used a Dutch auction instead of the typical underwriter-driven process. All investors could bid, and the minimum acceptable price was $85 per share. This cut costs and diversified the investor base. Google raised $1.67 billion. The stock ended day one at $100.34 (an 18 percent gain) and eventually increased more than 700 percent by 2013.

Facebook (2012) was the opposite story. It raised $16 billion at $38 per share. The opening-day P/E ratio was about 100 (Apple’s was 14). The stock briefly touched $43 but finished the day barely above the open price. Three months later, it was at $20, down 48 percent. The lesson: a great company can still be a bad investment if the price is too high. Some investors just hoped for a quick “pop” and did not care about valuation.

IPO Abuses

Madura covers several shady practices that have occurred:

Spinning: Allocating IPO shares to corporate executives who might hire the underwriter in the future.

Laddering: Brokers encouraging investors to bid above the offer price on day one to create artificial momentum.

Excessive commissions: Charging high fees when IPO demand is hot, knowing investors will pay because of the expected first-day return.

Distorted financial statements: Groupon went public in 2011 at $20. It understated expenses and exaggerated earnings. Within a year, the stock was at $3. An 85 percent loss for IPO investors.

Stock Exchanges

After the IPO, shares trade in the secondary market on stock exchanges.

The New York Stock Exchange (NYSE) is the largest. It merged with European exchanges to form NYSE Euronext and was later purchased by Intercontinental Exchange (ICE). By the time of that purchase, only about 20 percent of NYSE trades were executed on the physical trading floor. Most happen electronically.

The Nasdaq is an electronic exchange where many tech companies trade. Apple and Intel are Nasdaq stocks. Over 3,000 stocks trade there.

The OTC Bulletin Board lists penny stocks (under $1 per share). Very limited liquidity, mostly individual investors. The pink sheets are even smaller, with minimal financial data and very thin trading volume.

Stock exchanges publish key quotations: 52-week high and low, dividend, dividend yield, P/E ratio, volume, closing price, and net change. These give investors the basic snapshot they need.

Major indexes track market performance. The Dow Jones Industrial Average covers 30 large firms. The S&P 500 covers 500 large firms and is more representative. The Wilshire 5000 is the broadest U.S. market index.

Monitoring and Corporate Governance

When ownership is separated from management, agency problems arise. Managers may serve their own interests instead of shareholders’. This is where monitoring comes in.

Stock analysts rate companies (Strong Buy, Buy, Hold, Sell). But historically, they have been too generous. Their bonuses were sometimes tied to how much business they generated for their firm, not the accuracy of their ratings. New rules in 2002-2004 tried to fix this by separating analysts from advisory divisions.

Boards of directors are supposed to supervise management. They ensure compliance, internal controls, and ethical conduct. But boards can be ineffective if they are too close to management.

The Sarbanes-Oxley Act of 2002 (SOX) was a direct response to corporate scandals like Enron and WorldCom. It requires CEO and CFO certification of financial statements. It mandates independent audit committees and restricts auditors from providing non-audit services to their audit clients. It increased penalties for securities fraud. SOX made corporate governance more rigorous, though critics argue it increased compliance costs significantly, especially for smaller firms.

My Take

This chapter is full of contradictions. The IPO process is supposed to raise capital efficiently, but the underpricing problem means companies routinely leave millions on the table to please institutional investors. Rating agencies and analysts are supposed to provide unbiased information, but their incentives push them toward optimism.

The Google vs. Facebook comparison is instructive. Google used an auction and let the market set the price. Facebook went the traditional route and ended up overpriced. A great product does not equal a great stock price.

The long-term underperformance of IPOs is something every investor should know. The hype around going public often makes it seem like buying IPO shares is free money. It is not. Over time, many of these investments underperform the broader market.

The fundamental tension in equity markets is between investors who want transparency and managers who want flexibility. Sarbanes-Oxley pushed the pendulum toward transparency, but the game of managing perceptions versus managing the actual business continues.

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