Section outline

  • Module Homepage

  • 1. Introduction

    Welcome to "Initial Public Offering (IPO)!" The purpose of this module is to take a closer look at public equity financing and the various ways firms have to tap into this source of financing. This introductory section motivates the topic and explains the logic of the module.
    IPO Word Cloud  

    The main learning goals of this module are:
    • Get to know the most prestigious way to raise capital: the Initial Public Offering (IPO).
    • Know the costs and benefits of going public.
    • Understand the IPO process.
    • Know how an IPO allocates value and ownership (who makes how much money).
    • Know the costs and benefits of alternative going public strategies, including direct listings, direct public offerings, or initial coin offerings (ICOs).
      Activities: 4
    1. 2. Why Go Public?

      This section focuses on the main costs and benefits of going and being public. First, it is important to note that only few companies qualify for public listing, as most exchanges have fairly stringent listing requirements. But even for those firms who qualify, it might be questionable if the benefits of going and being public outweigh its costs.

      While the decision to go public is often associated with direct value creation, cheaper access to financing, greater visibility, as well as operational gains and governance improvements, it also brings about significant costs. First, the process to go public itself is costly and the total costs can amount to 25% or more of the IPOs gross proceeds. In addition, there are indirect costs to be considered, including ownership dilution, greater compliance and disclosure requirements, increasing information asymmetry between the firm and its shareholders, as well as increasing managerial myopia as a result of a change in focus on quarterly earnings per share (EPS). Firms should carefully balance these costs and benefits before initiating the going public process. In fact it seems that the costs have recently outweighed the benefits, as the number of publicly traded firms has decreased significantly since the late 1990ies.

      Activities: 3
    2. 3. The IPO Process

      This section starts with a general overview of the various ways firms can tap into public equity markets. Then it turns to the traditional way of going public via Initial Public Offering (IPO). It presents in detail the relevant steps a privately held firm must take to convert into a publicly held corporation.

      • In a traditional IPO, this process starts with the choice of investment bank that orchestrates the whole IPO process and underwrites the securities.
      • Next, it is crucial to stay on top of all the regulatory and disclosure requirements and, ultimately, prepare a listing prospectus that is in compliance with the requirements of the securities regulators.
      • One of the key roles of the underwriting syndicate is in the marketing, pricing, and placing of the firm's securities. We discuss how investments banks typically do this using roadshows and a price-discovery mechanism called bookbuilding
      • We see that IPOs are typically underpriced so that investors who buy shares from the investment bank can expect to earn a return of approximately 15% on the first day of trading, on average. We inquire into the reasons why IPOs are underpriced and discuss the cost implications of that underpricing.
      • We summarize the traditional IPO process using the case of Dropbox in March 2018.
      • Finally, we look at an alternative pricing mechanism, namely Dutch Auctions, and discuss reasons why that mechanism is not popular, despite its apparent pricing advantages.
      Activities: 3
    3. This section provides a relatively simple model to better understand how IPOs affect the value allocation as well as the ownership structure of the issuing firm. After a brief overview of the model, we build it step by step, namely:

      • Step A: Computation of the IPO net proceeds
      • Step B: Estimation of the firm's post-IPO equity value
      • Step C: Estimation of the market value offered to the primary investors
      • Step D: Analysis of post-IPO ownership structure
      • Step E: Computation of the number of shares that will be issued and sold
      • Step F: Determination of the share issue price and the post-IPO stock price.

      This simple model provides powerful insights into the relevant cash flows associated with an IPO, the pricing of the firm's shares, as well as the costs associated with an IPO. It also shows to what extent an IPO dilutes the ownership structure of a firm and why an IPO might still be a financially attractive way of financing, despite its substantial costs.

      The model is fully implemented in the Online Tool "IPO Mechanics," which is listed below.

      Activities: 5
    4. We conclude the module with a discussion of alternative ways to tap into public equity markets. We start with Direct Listings, where firms "simply" list their existing shares without raising any additional capital. Next, we discuss Direct Public Offerings, where firms issue shares to public investors without subsequently listing them on a stock exchange.

      We also discuss how the ongoing technological disruption might reshape financial markets. At its heart, digitalization is all about removing intermediaries and converting existing markets into platforms or ecosystems, on which demand and supply meet.

      Clearly, these technological innovation have great potential to make public capital accessible to many more firms and investors. Thereby, they can make an important contribution towards the democratization of investments.

      We discuss recent trends in Crowd Financing and how these platforms attempt to dismantle information asymmetry and bring firms and investors together. We also take a look at the potential benefits that the emerging blockchain technology and the associated Initial Coin Offerings (ICOs) might bring. It takes no crystal ball to see that, once established, this technology has the potential to fundamentally reshape existing financial markets.

      Activities: 3