Undervaluation of Initial Public Offer


An initial public offering of any company stock is the sale of company stock to the public. The company does this mostly to increase its capital. This essay looks in detail at the initial public offer’s process, definition, and the elements in the initial public offer.

History of IPO and IPO underpricing

The first-ever IPO was undertaken in 1602. This was carried out by the largest company of that time which was the Dutch East India Company. The company is said to have increased its capital base through the issuance of stocks and bonds. IPO underpricing has been used as a strategy to attract more investors, as will be discussed later, and has been in use for a long time since the 20 century.

Reasons for listing

IPO does allow a company to raise funds for use in various corporate operational areas like acquisitions, mergers, working capital, research and development, expanding plant and equipment, and marketing (Grobstein, Horwath & Company, 2011). Some other reasons for listing are liquidity, valuation, and the need to have more wealth without losing control. Liquidity can be viewed from the following perspective: “the shares once traded have an assigned market value and can be resold; this is extremely helpful as the company provides the employees with stock incentive packages and the investors are provided with the option of trading their shares for a price” (Grobstein, Horwath & Company, 2011, p. 1). Valuation is another reason for listing and has been viewed from the following perspective:

The public trading of the shares determines a value for the company and sets a standard. This works in favor of the company as it is helpful in case the company is looking for acquisition or merger. It also does provide the share holders of the company with the present value of the shares. (Grobstein, Horwath & Company, 2011, p. 1)

Lastly, listing makes it possible for a company to have increased wealth for the founders as the founders of the companies have an affinity towards IPO as it does increase the wealth of the company, without dividing the authority as in case of a partnership (Grobstein, Horwath & Company, 2011).

Disadvantages of IPO

Going public has many costs which may strain the financial base of any company. Some of the costs incurred by a company when going public include expenses associated with regulatory measures, legal and auditing costs. A successful IPO takes time to complete with some taking up to a year (UCLA, 2011).

Going public increases the number of duties that the management will have to carry out. The management will have to ensure that the company is compliant and satisfies all the requirements of listed companies. More time has to be created to prepare and publish the financial documents of the company. Since the management becomes accountable to the public, there is that pressure of ensuring that everything is carried out as expected to the public image of the listed company. Listing companies exposes them to more scrutiny. Many aspects no longer belong to the private domain. The payments arrangement for the senior management is made public, and there is a continuous scrutinizing of the company especially about its financial performance. Any action which may slightly reduce the price of the shares of the company is brought to light. This has the effect of putting the management under a lot of pressure to perform especially when the company is still new in the listing.

The management is even subjected to more pressure as they are expected to come up with clear long-term plans for the progress of the company. The management is required to draw a convincing path that shows how the company will proceed to financial stability; such a plan may include aspects like the path to future developments of new products, new branches which are likely to be started among others. It is business nature that sometimes long-term goals may conflict with short-term goals. In such a case short-term goals may bring profits which in the long may lead to the company making losses. In such a situation there is usually a likelihood of a conflict arising between the management and shareholders who may more likely prefer the short-term benefits (UCLA, 2011).

It has been noted that the key employees of a listed company may not enjoy the privilege of trading in the shares as in some cases it might be considered as a case of insider trading. A listed company may also be a target of a takeover by a group of people or even another company and this may likely be the case when the shareholders are not satisfied with the running of the company (UCLA, 2011).

Major decisions will take a good amount of time because the key strategic partners, shareholders, have to be included. Due to the huge number of shareholders, such decisions are time-consuming and may not single out the best alternative. Thus there is a loss of flexibility on the side of the management which may, in turn, lead to losses in the events those quick decisions touching on vital issues are required (UCLA, 2011).

Listing a company exposes the company to risks because mistakes they would have done without being punished will have to be punished once a company is listed, for instance, if the employees engage in misrepresenting the financial position of the company at the time of listing then it this is revealed the employees are likely to face the consequences which include being sentenced. The management has always to ensure that the decisions they make are lawful and otherwise they will be risking being sued.

IPO Procedure

If a company is preparing to go public, it first hires an investment bank to carry out the underwriting; the company can raise the money through debt or equity. Underwriters usually act as a link between the public who are investors and the companies. Then the investment bank and the company will first start the process of deal negotiation whereby important issues touch on the underwriting process; some of the issues discussed include the amount of money to be raised, the type of securities to be used in raising the capital among other issues touching on the IPO (Grobstein, Horwath & Company, 2011).

The first stage has to do with coming up with a capable team that will steer the company into the IPO. Such a team will characteristically consist of the company lawyers and key personnel from the company. Some of the duties that this team is likely to accomplish are coming up with a time schedule for various duties, drawing up responsibilities and how they will be shared among others.

The investment bank gives the registration certificate after the above team has completed its work. The certificate is then submitted to the Securities and Exchange Commission. The registration statement which is usually written to the securities and exchange commission of any country has the following information: “the prospectus summary, risk factors, use of proceeds, capitalization of the business, selected financial data, underwriters, and the names of the employees, principal stakeholders and the management team” (Grobstein, Horwath & Company, 2011, p. 1).

The second stage involves the preparing of a preliminary prospectus also called a red herring because it bears a proviso on the cover which is printed in red ink stating that the prospectus is not yet final and the content may not be final. This document has the following information: “name of the company, date of offering, a description of the securities being offered, how the proceeds are expected to be used by the company, the offering price, the market for the securities and the anticipated net proceeds to the company plus name of underwriters and certain information about the underwriting agreement” (Grobstein, Horwath & Company, 2011, p. 1).

Another description in the preliminary prospectus is that touching on financial information which gives the following details: “company’s profits, capital structure, details of corporate debt and the audited financial statements dating back to three years plus unaudited financial statements” (UCLA, 2011, p. 1). The red herring also includes detailed information on management, directors and principal shareholders. The disclosure of all material acquisitions and disposals that had taken place in the previous two years prior to preparing the prospectus is disclosed. The last content on the prospectus is the management discussion and analysis which discusses the operating results and liquidity of the company (UCLA, 2011).

Stage three is the process of undergoing due diligence, where lead underwriters and their lawyers conduct a thorough investigation on all aspects of the company. This gives them relevant information about the prospectus to be sure that all the information offered is true. It is an investigation to provide reasonable grounds for a belief that they have been no misrepresentation. It gives investors objective and reasonable assurance that the prospectus is true. Here lawyers will do a thorough review of the business property and investigate all financial information, tax matters, litigation matters plus corporate financing, and security matters. Lawyers will also look at the HR policies from the list of employees, organizational charts, collective bargaining agreements, and details of union activities. From here, the management questionnaire is prepared for officers and directors of the company to shed more light on the prospectus and more information about the directors and senior officers of the business (Grobstein, Horwath & Company, 2011).

The next step is the close inspection where underwriters and their lawyers will visit the company premises to inspect the facilities. They may even contact the business customer’s suppliers and others whom the company does business with and hold meetings with the company directors, auditors and other advisors. The last step here is the preliminary due diligence call held with management and all its key advisors. The purpose of this meeting is to clarify that all the information collected is true and depicts the financial position of the company (Grobstein, Horwath & Company, 2011).

The fourth stage is a regulatory review which comes after the agreed prospectus is printed and filled with relevant securities commissions. Depending on the activity in the markets, the securities administrators will usually issue a comment letter within two weeks outlining the point of clarification, required revisions, requests for further information and any other questions (Grobstein, Horwath & Company , 2011).

The fifth stage is the marketing of the IPO. This is all about presenting the company information to potential investors. Whatever the investors are told about the company must be convincing enough otherwise failure to convince the investors will be a missed opportunity. Time for marketing is short and the primary information document is the primary prospectus that provides the basis for the ‘green sheet’. The green sheet is prepared by the underwriter and is usually a summary of key information from the prospectus mostly containing comparatively data on similar stocks (Grobstein, Horwath & Company , 2011). The fifth stage is used to bring out the unique attributes, financial performance and the growth expectations of the company. If there is greater interest, then there is a likely chance of success of the IPO. The fifth stage takes 8-10 days in the United States; it can be either through one-on-one presentations, conference calls, or group presentations to potential investors. Book building is also employed in the fifth stage. Book building is where retail investors usually submit a market order in which the quantity desired is stated. Institutions usually submit limit orders where the quantity demanded is subject to a maximum price. Institutions tend to submit an order with a commitment to purchase more shares in the open market if their order is fulfilled (Grobstein, Horwath & Company , 2011).

The sixth stage is the update on due diligence. Mostly before the final presentation of the final prospectus, the working group of advisors will hold a meeting to update the due diligence. This actually gives all the parties an opportunity to raise any questions they may have about the offering or the company (Grobstein, Horwath & Company, 2011).

The seventh stage is that of preparing the final prospectus. The final prospectus is usually affected by the general market conditions and the interest generated by the company or business while using the preliminary prospectus are known to affect the final decision on pricing and number of shares to be issued. The working group usually comes with the final price and offering size. It is from here that the final prospectus is filed and a receipt obtained from the securities commissions. The selling and distribution of shares may begin here (Grobstein, Horwath & Company, 2011).

The last stage involves the winding up of the underwriting agreement. At this stage the necessary legal documents are exchanged and the company is given the funds which are exchanged with the securities. After this stage the life of the company then continues but as a public listed company (White, 2001).

Underwriting of an IPO can be carried out in one of the following ways: “a firm commitment basis or best effort basis” (Findlaw, 1999, p. 1). When the IPO is carried out on a firm commitment then the agreement is that “the underwriters usually purchase the shares at a discount of 7% to 10% and resell them to the public offering price to institutional and individual investors” (Findlaw, 1999, p. 1). For the other option, best effort, the players act in a good faith and do all they can to ensure that the shares are all sold. Investment banks are sometimes included to diversify the risks associated with shares. The inclusion of investment banks is done by the management underwriters. The risk diversification is carried out as detailed below:

Then the managing or lead underwriters may reduce their risks by allocating shares to other investment banks. Sometimes the syndicate members may participate in purchasing or reselling of shares or they may just market the shares to their respective individual and institutional clients (Findlaw, 1999).

It is worth noting that the company auditors have some very vital to play in the whole process of processing the IPO. The company auditors in most cases work in close coordination with the chief financial officer of a company to ensure that the disclosed information depicts the true financial position of the company and that if there is some information not yet disclosed in the prospectus then such is done to avoid lawsuits. It is therefore the role of the company auditors to countercheck and ensure that all the documents which are submitted to the relevant filing and registration authorities are true disclosures of the financial position of the company (Findlaw, 1999).

The legal counsel at the same time will carry out duties similar to the company auditors. The legal consul consists of two groups of lawyers with one group representing the underwriters and the other representing the company. The consul is generally meant to ensure that the IPO process runs smoothly and does not hit any technical mistakes especially from the perspective of the legality of the whole process. This is achieved by ensuring that the necessary documents are prepared by the law as it stipulates on the issue of IPO. The legal consul also goes through all the company documents to certify them and ensure that they do not become an obstacle to the IPO process (Findlaw, 1999).


These are used to set the prices of shares. An auction was applied by Google and is mostly used in US treasury auctions, also referred to as a descending price auction. The Dutch auction uses a bidding process to find an optimal market price for the stock, which is the “lowest price at which an issuing company can sell all the available shares” (Notes, 2011).


Here the working group meets to discuss and share the feedback and ascertain demand and pricing, they agree on a final pricing date, investors are told the deadline for submitting indications of interest and the closing of the books. When the books have been closed, the lead managers and co-managers assess demand, price sensitivity, allocation issues and aftermarket behavior (Grobstein, Horwath & Company, 2011).

Then a lead manager meets the co-management and they recommend an offering price that usually maximizes the offering proceeds to company and favorable aftermarket performance. The company and the underwriters agree on offering price and later sign underwriting and syndicate agreements (Grobstein, Horwath & Company , 2011).

Underpricing and its causes have been researched before by scholars and some theories developed to explain:

The first theory explaining IPO under pricing is the Adverse Selection Theory. It was developed in 1986 in a study by Rock; it tends to divide the investors into two major classes, the informed and the uninformed investors. This theory says that the informed investors do actually know the true and real value of the stock compared to the uninformed investors who naturally tend to invest randomly without any knowledge of the company stock’s true value. (IWU, 2004)

The other theory is the Adverse Selection Theory which assumes that the financing body is well informed of the financial position of the company in question and is in a good position to offer any advice on the share offers (IWU, 2004).

It is common for the company stock to vary prices due to market forces of demand; note that the supply does not change as it is a given value which is known, that is, the capital realized through the IPO.

This leads to demand being separated into two categories: informed investor demand and uninformed investor demand.

It has been argued that in ideal situations, informed buyers would easily reap great benefits as they would only go for the best IPOs. The situation which will likely occur in such a scenario is that the uninformed investors may opt-out of participation in the stock market:

Uninformed investors would choose not to participate in the IPO market, thereby cutting the demand for stock in IPOs.

This drop in demand for IPOs would leave less promising issuing firms with undersubscribed IPOs. Complicating this problem is the fact that investment banks participate in share rationing of very promising IPOs to preferred customers. If these less informed investors had a better chance of obtaining shares of these high value IPOs, less underpricing would be necessary to keep their demand for IPOs in the market. (Virginia University, 2004, p. 1)

The relations of the investment bank and issuing firm have been pointed to sometimes lead to underpricing. This is explained through the Hazard Model whereby issuing firm depends on information obtained from third parties, auditors and financing banks, to come up with the value of the shares. An agreement is usually drawn up when the issuing firm is coming up with the price:

First, the contract price must meet certain minimal levels of expected returns to the investment bank. Secondly, the price of the IPO must be low enough to induce the investment bank, the agent in this scenario, to act in the issuing firm’s best interest. (IWU, 2004)

The issuing firm has an obligation of getting the correct information from the financing body. All the parties, the issuing firm, the financing body, and the underwriters have to work together for the benefit of the company. It has been noted that the information obtained will either may or may not lead to underpricing. If the issuing firm does not have faith in the financial position of the company then the likelihood is it will be a case of underpricing. The contrary takes place when the company going has known strong financial position. It is correct therefore to argue that the case of underpricing arises when the issuing firm suspects that the company going public does not have a very strong financial background or rather its future does not seem to be very promising. However, it should be noted that to clear out guesswork and suspicion then there is a need for the financing body and the underwriters to give as much relevant information as possible to eliminate the game of speculation.

There have been suggestions that the reputation of the firm carrying the auditing exercise and to some extent the investment bank carries a lot of weight in the IPO process especially in the setting of the prices of the offers. There has been a general assumption that companies that engage high-profile auditors when going public end up having the prices for their offers highly priced. It has been assumed that companies using the services of the high profile auditors and big investment banks likely have a bright financial future and for this reason the issuing firm will tend to price such offers highly (IWU, 2004).

It has further been argued that a company which seeks the services of a reputable auditing firm is probably because it wishes to have its true position accurately brought implying that such a company has confident and reliable management and that it has been managed well before implying that it has a bright future thus the high likelihood of such a company giving its offers highly-priced. The benefits of having a reputable auditor are evident especially when a case of security litigation arises. The investors will enjoy a high level of flexibility as it will be possible for them to easily get their investment in case of litigation. This will possible since the auditing firm being reputable is expected to be financially stable (IWU, 2004, p. 1).

Consistent with the above arguments, it has been pointed out that the size of the deal has an indirect correlation with the price of the offer such that smaller deals are likely to register high underpricing.

Issue Price

It is the price at which new shares are offered to the public when a company goes public in the Securities and Exchange Commission (Notes, 2011).

Quiet Period

A quiet period is divided into two periods: before and after the trading of the new shares. This is actually the time when the insurer is not allowed to promote a new issue, also called the waiting period. Begins from the filling date when the securities are registered by the Securities and Exchange Commission. After the first day of the IPO, the following are required to be quiet on issues touching on the company: “insiders and underwriters involved in the IPO are usually restricted from issuing any new earnings forecasts or research reports for the company” (Notes, 2011)

Stag Profit

Stag profit refers to the period when a firm has floated new shares in the market and thus equally refers to the time after an IPO. In most cases, there are profits realized by a stag during this time. A person who buys the shares and sells them immediately at the beginning of trading is referred to as a stag and thus the profit realized out of this process is the stag profit (Notes, 2011). Thus ideally stag profit is the difference between the price of shares as set by the issuing firm and the price of the shares as set by the market forces at the beginning of stock trading. It thus should be observed that the possibility of making a “stag loss” does exist.


It is clear that for a company going public, they are a lot of benefits gained mostly due to exposure and getting capital very easily. Companies that go public enjoy a lot of prestige in the public domain as a lot is known about them compared to private companies. It has been noted that the process of carrying out an IPO requires that a company takes a lot of care especially to avoid making legal mistakes since the company will be venturing into the public sector. Therefore, when a company is preparing to go public it does make use of lawyers and auditors among other key officials. The principal aspect which ought to be upheld in the whole process of preparing a company for an IPO is ensuring that there is transparency.


Findlaw. (1999). Initial Public Offering. Web.

Grobstein, A., Horwath, G & Company. (2011). Initial Public Offers. Web.

IWU. (2004). IPO. Web.

Notes. (2011). Initial Public offering. Web.

UCLA. (2011). IPO. Web.

Virginia University. (2004). Initial Public Offers. Web.

White, A. (2001). Initial Public Offeres. Web.

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