Reading: IPO Mechanics

C: Market Value Offered to Primary Investors

From Step A, we know that the firm and the selling shareholders together expect to collect net proceeds of $345 million. In exchange, they offer shares in the company. However, the total value of the offered shares does not correspond to the net proceeds the firm collects. The reason is twofold:

• The intermediary (the underwriting syndicate) charges a commission for marketing and placing the shares. This underwriting discount is subtracted from the issue price the primary investors pay. In our example, the underwriting discount is 7%. Put differently, of each dollar the underwriting syndicate raises from the primary investors, the underwriters keep 7 cents as a commission and pay the remaining 93 cents as net proceeds to the firm and the selling shareholders.
   
• The primary investors are not willing to pay the full price of the shares. In exchange for their participation in the underwriting process, they generally ask for an underpricing of the securities. In our example, the underpricing is 15%, meaning that the primary investors expect to earn a return of 15% when buying shares from the syndicate at the issue price and selling them through the stock exchange at the end of the first day of trading. Put differently, for each dollar they pay as gross proceeds to the underwriters, the primary investors expect to receive shares with a market value of $1.15 in return.

Consequently, to obtain the market value of the offered securities, we proceed as follows:

• Add the underwriter discount to the net proceeds to obtain the gross proceeds of the IPO. The gross proceeds indicate the total amount of money the syndicate raises from the primary investors.
• Add the underpricing to the gross proceeds to obtain the market value offered.

Formally:

\( \text{Net Proceeds} = \text{Gross Proceeds} \times (1-\text{Underwriter Discount}) \)

\( \longrightarrow \text{Gross Proceeds} = \frac{\text{Net Proceeds}}{(1-\text{Underwriter Discount})} = \frac{345}{1-0.07} = 371.0 \)

and:  

\( \text{Market Value} = \text{Gross Proceeds} \times (1+\text{Underpricing}) = 371 \times 1.15 = 426.6 \)

The following table summarizes the steps from the net proceeds the firm and the selling shareholders collect (excluding direct costs) to the market value of the securities they offer in return: