The Initial Public Offering - Case Study Example

The initial public offering (IPO) of a firm often occurs at time that represents a balance between its youth and maturity (Brau et al., 2005, p. 14; Cohen, 2002; Maug, 2001, p. 1; Ritter, 1998, p. 17). The IPO is defined by the firm's offering up securities to the public to be bought in the form of shares. The process involves investment by a bank as the initial buyer, then registration with the national commission for exchange. Registration includes detailing the business model of the organisation, as well as its history, economic performance, and other relevant information. Once this is approved by the commission, the bookbuilding process begins, in which the company is introduced to potential investors, who then explicitly express their interest in the venture. At this point, the investment bank proposes a price to the company, and later the trading begins (Ljungqvist, 2005). This process is often very complicated and very costly. The costs are generated by auditing and underwriting, plus legal fees. Ongoing costs are also associated with public offerings, such as those connected with supplying information and dividends to investors (Ritter, 1998, p. 1). Another cost related to going public may come from underpricing, which is a risk that grants initial investors less than the market value of the securities through offering it at too low a price (Clementi, 2005; Ljungqvist 2005; Ritter, 1998). The theories that explain why a firm might do this are several. They include the desire of entrepreneurs and/or investors to lower capital cost and to broaden the firm's ownership base (Brau et al., 2005, p. 5). Other theories suggest that firms decide to go public for reasons of legitimacy and growth (Cohen, 2002). Still others posit the theory that initial public offerings usually occur as a normal stage in a firm's lifecycle (Brau et al., 2005, p. 13; Maug, 2001, p. 1; Ritter, 1998, p. 18). Small firms are usually run by a limited amount of capital. This is usually sufficient in the very short run, but when firms begin to grow, continuation of this growth is often dependent upon the availability of capital (Brau et al, 2005, p. 4). In order to obtain this capital, firms will choose to offer securities on the public capital market. Theorists argue that the rationale for choosing this is strengthened by the fact that the benefits of liquidity is more desirable for entrepreneurs than compensating investors for the non-liquidity that usually exists in privately owned firms (Ritter, 1998, p. 1). This might be viewed in terms of the desire to reduce a firm's capital costs. A major part of capital costs comes from debt. This is concretised roughly by the interest rate payable on the amount of debt incurred in the financing of the firm. When liquidity is necessary, rather than incur this (or additional) debt, firms might choose to raise capital by selling is equity in the form of securities to the public (Ritter, 1998, p. 1). The same might be done to its debt via an initial public debt offering (Ritter, 1998, p. 1). The life-cycle theory has been propounded by several financial theorists. It states that the IPO occurs within the normal process of a firm's evolution and maturity (Ritter, 1998, p. 1; Brau, 2005, p. 13). The small business is usually at first financed by the owners' limited capital. When growth beyond this capacity is necessary, and all other private avenues (friends and family) have been exhausted, capital is sought from non-affiliated financial sources, such as banks and venture capitalists. However, entrepreneurs and investors will likely not agree on all decisions to be made within the firm. At this point firms consider it desirable to offer its securities to a highly diversified public (Ritter, 1998, p. 18; Boehmer & Ljungqvist, 2004, p. 28). Firms are interested obtaining financing at the cheapest cost. The cost of capital theory can be invoked here as well, since equity does generate a cost (though one much more difficult to calculate than that of debt). When a firm offers its shares to the public whatever costs equity incurs is offset by the capital to be gained from the sale. However, with the public as a further investor in the company, future profits must be shared with them as well. Therefore the IPO offers an opportunity, as well as the possibility of liabilities. This gives one reason why the life-cycle theory causes the IPO to occur at a stage where the other possibilities for financing have been exhausted (Brau et al., 2005, p. 13). Firms have noted that announcements about going public have often increased the growth of revenue and widened profit margins (Boehmer & Ljungqvist, 2004, p. 1). The conditions of the stock market, too, have an impact on the decision of the firm to go public as well as the timing of this event. Since firms have the desire to maximise profit, the increase in revenue from going public might be attractive despite a certain amount of loss of control that comes along with public offerings. The bandwagon theory (which has much to do with underpricing) is comparable here, as it too has much to do with the fluctuations of investment activity within the stock market (Helwege & Liang, 2002). What sometimes results is a positively sloped demand curve, and this prospect often lures entrepreneurs toward the IPO. During such times, the cost of capital, though not explicitly mentioned, also has some bearing. The increase in revenue that comes not just from the sale but also from the increase in the value of the company shares does offset the capital costs of the firm. Such conditions are favourable to entrepreneurs (Boehmer & Ljungqvist, 2004, p. 6). Other theorists have cited motives of prestige and legitimacy for a firm's pursuance of an IPO (Cohen, 2002; Brau et al., 2005, p. 8). Cognitive legitimacy (the situation in which a firm is taken for granted within the market) is a desirable quality as it represents the dominance of the firm within the market and the difficulty rivals would have of effacing its share of the market. A firm might be desirous of gaining, maintaining or repairing its legitimacy in its decision to offer securities to the public. In this theory capital gain, though important, does not hold the prominent position. The launching of a firm onto the public market allows a greater amount of visibility to that entity. The firm might also for the first time be considered a serious player in the business world. This legitimacy allows the firm access to resources beyond the level of capital. Suppliers now become more readily available to the firm, as do clients, and possible partners. The firm also becomes more in line to receive governmental support, as its ownership becomes more of a publicly held title than a solely private concern. In addition to this, the visibility granted the firm is a major advertising opportunity, and a larger customer base can rapidly accrue as a result of a public offering (Cohen, 2002). Underpricing is a phenomenon that would (unlike the previously mentioned factors) seem to adversely affect the profitability of a firm's entering the capital market. Yet it occurs during virtually all IPO's (Ritter, 1998, p. 4), and this has been explained by theorists through examination of the role of the underwriter. The underwriter does take a risk in agreeing to buy and then market the firm's securities. The underwriter who sells to investors must consider the fact that if an investor should choose to reject the allocation, the underwriter would be left with a certain number of shares which must be sold in the aftermarket. Because these investors buy shares in such large numbers, each will have the power to significantly lower share prices in the aftermarket. In such an event, the underwriter would lose from shares unsold in the IPO. The underwriter therefore offers the investors the prospect of a premium by underpricing the shares at the IPO. Related to this is the existence of premiums and discounts on the Net Asset Value (NAV) of shares (Bruce, 2001). The underwriter would presumably more willing to invest in the firm's IPO if premiums are likely to be gained on the shares once they hit the market. This would occur if the market value of the share exceeds that of the NAV (Pritsker, 2005, p. 3). In the opposite case, the effect would be that of a discount. Since the underwriter is able to sell unaccepted allocations of shares in the ensuing market, then the prospect of premiums would be attractive enough for them to aid the firm in its initial public offering. However, it is partly because of the risk also associated with this that firms must also pay high fees to underwriters-the equivalent of approximately 7% of the capital gained by the firm from the IPO (Pritsker, 2005, p. 1). It is therefore in the firm's best interest to know with a significant degree of certainty what its value per share would be, as uncertainty will generally lead to greater underpricing (Givoly & Shi, 2003, p. 5; Ritter, 1998, p. 18). In general, the shipping industry has been dominated by firms that are owned and operated privately. Usually the owner of the ship(s) makes all the decisions regarding when and what to buy, sell or charter. In recent years, ship owners have come to understand the difficulties involved in operating a growing business. Some ship companies have chosen to go public while others have tried to refrain from this. The reasoning behind these decisions hinge on some of the ideas and theories previously presented. The decision of the shipping company Dryships to go public supports the theory that entrepreneurs and investors are attracted to liquid markets. When one investor with Dryships was questioned regarding the decision of the company to do an IPO, the reply directly pointed toward the liquidity that existed in the market at the time of the offering (Welling, 2005, p. 1). The current chairman and CEO of Dryships, George Economou, with full disclosure managed sell 15 million shares and raise $270 million in capital, selling each share at $18 (Welling, 2005, p. 2). The company is known to have used the capital to purchase some more vessels: eight Panamaxes and two Capesizes. This is evidence that the public offering of the company was done to facilitate the gaining of capital for the further expansion of the business. The drawbacks of IPO's that have been cited, such as the necessity to communicate with diverse shareholders and the need to dividends, appear to have also been considered as such by the managers of Dryships (Ritter, 1998). The company's disclosure revealed its intention to pay dividends, but "with heavily qualified language" which indicates that during times when its yields are low, its ability to pay these dividends might be reduced (Drybulk IPO, 2005). This necessity to protect itself from having to pay dividends in low-yield times highlights the idea that this firm's IPO occurred most likely because all other sources of capital had already been tapped and the IPO came as a last resort. The firm also represents one that is likely to have embarked upon an IPO in the hope of gaining benefits from the premiums on Net Asset Value (Pritsker, 2005, p. 3; Ritter, 1998). One option of re-investing its net revenue is through the acquisition of even more ships to add to its fleet. However, the company indicates that in the event that ships are unavailable, it would seriously consider reclaiming some of its jettisoned stock, especially if they generate premiums by falling below the NAV. Although the firm began its offering of dividends conservatively at $0.20 per share, the stock value did climb from $18 to $23.75 with a dividend increase to $0.80 within the year (Drybulk IPO, 2005), suggesting that the firm's decision to go public was a good one. According to the theory of IPO's as a natural stage in the lifecycle of a company, Dryships may also have decided to perform and IPO as the natural next step in the company's evolution. The company is 70% controlled by the Entrepreneurial Spirit Foundation, and this suggests that its lifecycle had progressed beyond the stage of venture capital (Welling, 2005). It might be considered, therefore, that this company also chose the IPO as a method of expanding its ownership base beyond control of its investors. This too is an indication of the theory of company lifecycles in practice (Brau et al., 2005, p. 13; Maug, 2001, p. 1; Ritter, 1998, p. 17). Another shipping company, Diana, also launched a successful IPO, fetching a price of $17 per share. In this case, capital gain can also be seen as the driving force behind the offering, as the company benefited from the event by selling shares worth $210 million (Drybulk IPO, 2005). One hundred and sixty-six million dollars worth of debt was cleared immediately after the offering (Drybulk IPO, 2005), which further indicates how the firm can profit (through reducing debt costs) from entrance to the capital market. Not only was there $54 million available after the payment of the debt, but that payment allowed them to secure a revolving credit of $230 million from a Scottish bank for the purpose of funding expansion in the future. Since this company had already grown to a fairly large size of nine ships (Drybulk IPO, 2005). This case therefore supports the idea that companies do IPO's to facilitate expansion beyond a certain point (Brau et al., 2005, 13; Ritter, 1998, 17). Diana can also be seen to have also taken advantage of the market at an opportune time, in that it offered its shares to the public when it was most likely to secure the highest prices for its stock. The time-charter quotes for its Panamax vessel during the IPO year (2005) was at $29,466. However, the following year's prediction reflected a decline to $22,625 and the year following that one to $17,167 (Drybulk IPO, 2005). This demonstrates the exploitation of the company's current prosperity to generate a high offering price, possibly in the anticipation of lower aftermarket prices that would generate a discount and make it possible to regain shares (if desired) at a later date. In any case, the current capital gain and the dispersal of risk through the IPO would reduce the losses to the company in the future if revenue did fall as predicted (Boehmer & Ljungqvist, 2004, p. 28; Pritsker, 2005, p. 3; Ritter, 1998). Another consideration is that Diana decided to IPO because of the legitimacy and prestige connected with a publicly owned firm. Especially for the Diana, with such dismal predictions for the future, the publicity could grant more access to suppliers and clients. In addition, as a company with a public interest, in the event of detrimental occurrences, it might be more inclined to get help from the government (Cohen, 2002). Many theories exist to explain why companies embark upon initial public offerings. It is usually the case, however, that empirical findings demonstrate that a combination of those reasons act as the catalyst that sends firms into the capital market. The Dryships and Diana shipping companies demonstrate that the need for capital does drive firms toward offering their shares on the public market. These two cases also demonstrate that companies often take advantage of timing, opting to sell its shares at the height of the company's financial existence, in the hope of gaining down the line through disparities of the offering, opening, and subsequent trading prices. As both companies contain sizeable fleets at the IPO, their cases also support the theory that a part of the natural evolutionary process of the firm is eventually to go public once other sources of capital have been tapped and exhausted. In the case of Diana, it was seen that it had already progressed to the stage at which large debts had been incurred. With Dryships, a 70% outside ownership also gives credence to this theory. References Brau, J., P. Ryan & I. DeGraw. (2005). "Initial public offerings: CFO perceptions, rationale for going public, perception stationarity, and after-market returns." FMA Online. Accessed on 1 May 2006. Available: http://www.fma.org/Chicago/Papers/Rational_Applied_in_the_IPO_Process.pdf Bruce, L. A. (2001). "Keep your eyes open for a good closed-end fund." Bankrate. Accessed on 1 May 2006. Available: http://www.bankrate.com/brm/news/investing/20010427a.aspkeyword=&authori d=22&firstn=Laura&middlen=&lastn=Bruce Boehmer, E. & A. Ljungqvist. (2002). "On the decision to go public: evidence from privately held firms." Accessed 1 May 2005. Available at SSRN: http://ssrn.com/abstract=266993 or DOI:10.2139/ssrn.266993 Cohen, B. (2002). "European IPO's in the U.S.: legitimacy and internationalization." Instituto de Empresa. Madrid. Accessed 1 May 2006. Available: http://www.babson.edu/entrep/fer/Babson2002/XIV/XIV_P1/P1/html/xiv-p1.htm "Drybulk IPO." (2005). Lloyd Shipping Economics. Accessed on 1 May 2006. Available: http://www.conconnect.com/Workingpapers/drybulkipoLloydsshippingeconomist may2005.pdf Givoly, D. & C. Shi. (2003). "Accounting choice for software development costs and the cost of capital: evidence from underpricing of initial public offerings in the software industry." Smeal College of Business/Graduate School of Management. U. California/Penn State. Helwege, J. & N. Liang. (2002). "Initial public offerings in hot and cold markets." Federal Reserve Board. Washington DC. Ljungqvist, A. (2005). "IPO underpricing." Handbook of Corporate Finance: Empirical Corporate Finance. Elsevier/North Holland. Maug, E. (2001). Ownership structure and the life-cycle of the firm: a theory of the decision to go public." European Finance Review. Vol. 167-200. Pritsker, M. (2005). "A fully rational liquidity-based theory of IPO underpricing and underperformance." Federal Reserve Board. Washington DC. Ritter, J. (1998). "Initial Public Offerings." Contemporary Finance Digest. Vol. 2(1), 5- 30. Welling, K. (2005). "The golden fleece Dryships' debut shows speculation, liquidity trumping experience." Welling@Weeden. Vol. 7(4), 1-3. Read More