Marketing an IPO issuer in early stages of the IPO process

Abstract

Successful marketing of an IPO issuer depends on the issuer’s attractiveness to early stage stakeholders such as underwriters and institutional investors. However, there is limited research on how these stakeholders evaluate IPO issuers. We investigate how a multitude of cues influence underwriter prestige and price shortfall. In addition, we draw on cue utilization theory and the attention-based view of the firm to hypothesize contrasting uses of cues by underwriters and institutional investors. An empirical examination of 119 IPOs using 2SLS identifies cues that help increase underwriter prestige and reduce price shortfall. Furthermore, our estimation reveals important differences between the two early stage stakeholders—whereas underwriters rely more on intrinsic cues to evaluate the attractiveness of IPO issuers, institutional investors rely more on extrinsic cues. These findings have important theoretical implications as well as normative implications for marketing an IPO issuer in early stages of the IPO process.

Appendices

Appendix A

Three stages of the IPO process

The IPO process entails several stages as shown in Fig. 1. Briefly, a new issuer (i.e., a firm interested in issuing an IPO) starts the IPO process by seeking an underwriter to represent it in course of the IPO process. (An underwriter is an investment bank tasked with marketing and underwriting the new issue.)

There is significant variability in the quality of new issuers as well as potential underwriters (Fernando et al. 2005). New issuers seek to engage the more prestigious underwriters because they have a larger array of resources, including talented analysts adept at applying and communicating valuation models (Roosenboom 2007). Conversely, underwriters seek to engage with high quality issuers (i.e., issuers likely to perform well in the future) because doing so improves the underwriters’ reputations, which increases their ability to attract future business (see Basdeo et al. 2006). Underwriters’ reputations get established over time and generally are well known in capital markets (Carter and Manaster 1990). In contrast, most new issuers are not well known in capital markets and do not have well established reputations prior to the start of the IPO process (DeKinder and Kohli 2008; Xiong and Bharadwaj 2011). As such, prospective underwriters face uncertainty about the quality of new issues. Underwriters try to reduce their uncertainty by making inferences of issuer quality using signals or cues (proxies of issuer quality) such as whether or not an issuer has venture capital backing (e.g., Fernando et al. 2005; Higgins and Gulati 2003).

After a new issuer has engaged an underwriter,⁷ the next legally required step in the IPO process is registration. It refers to the filing of an IPO Prospectus (S-1 form) with the Securities and Exchange Commission (SEC). Following this, the “road show” begins (Fernando et al. 2005). The purpose of the road show is to market the new issue to institutional investors, and get them to commit to purchasing shares of the new issue (Lowry and Schwert 2004).

A key point of focus during a road show is the expected price (i.e., an issuer’s asking price) per share of the new issue. The expected price is publicly announced in the S-1 document filed with the SEC prior to the road show. If the new issuer cannot attract institutional investors to pay the expected price (or a different price that is acceptable to the new issuer), the issuer exercises its right to withdraw its IPO registration (see Busaba et al. 2001). If the new issuer and institutional investors agree on a price (offer price), the new issuer receives cash from the institutional investors, and retail investors are offered the opportunity to purchase the issuer’s shares on publicly traded stock exchange (s).⁸

Importantly, the offer price agreed upon by a new issuer and institutional investors frequently is different from the original expected price (stated in the S-1 document). In fact, some IPO issuers receive less than 40% of their expected prices (e.g., Pharmion IPO in 2003). Differences between offer prices and expected prices are termed price shortfalls.⁹ These price shortfalls can occur because of information asymmetry between new issuers and institutional investors—they each value the shares issued based on the different information to which they have access (Daily et al. 2003; Sanders and Boivie 2004). A new issuer is likely to rely on its private knowledge of its performance potential. In contrast, institutional investors lack the issuer’s private knowledge and face greater uncertainty about the issuer’s quality. Institutional investors try to reduce their uncertainty by making inferences of the new issuer’s quality using signals or cues (proxies of issuer quality) such as the level of media coverage of the new issuer (e.g., Cook et al. 2006).

In the final stage of the IPO process, shares of the new issue are offered on a public stock exchange. In this stage, the final stakeholders in the process—the retail investors—have the opportunity to evaluate the new issuer and decide the price at which to buy and sell shares of the new issue. In many cases, the closing price on the first day of trading on the public exchange is higher than the offer price, a phenomenon termed underpricing (Brau and Fawcett 2006; Saboo and Grewal 2013). As is the case in the first two stages, there is information asymmetry between a new issuer and retail investors. Retail investors face greater uncertainty about the quality of the new issue, and try to reduce their uncertainty by making inferences of new issuer quality using signals or cues such as its R&D spending (e.g., Deeds et al. 1997; Xiong and Bharadwaj 2011).

In sum, a new issuer must attract three different stakeholders at three different stages in the IPO process: (1) underwriters in the very early stage, (2) institutional investors in the “road show” stage, and (3) retail investors in the last stage. Each of the three stakeholders face uncertainty regarding the quality of the new issuer.

Appendix B

Table 3 Variable definitions, measures, and data sources