Accounting For the Success of the IPO Market - Essay Example

Accounting For the Success of the IPO Market Introduction Organizations managers make critical decisions in the company regarding, investment of resources, financing decisions, dividends decisions, etc. So when the firm intends to expand its operations or carry out other financial activities, they may require substantial capital investments.1 The managers should make financial decisions that involve looking for funds to finance the investments. The sale of initial public offering (IPO) is one of the best methods of raising funds for long-term investment by a private company because the funds are permanent in the business. IPO refer to the first sale of stock in the security market by a private company to the public investors. Apart from raising funds a private firm can sell IPO for other reasons. With the help of an underwriting firm the issuer provides a prospect to the public giving detailing the reasons for issuance the authorized share price as well as the worth of the issuer.2 However, in the IPO market the investors and sellers hold different information that creates information asymmetry. The goal of this study is to examine the effects of information asymmetry between seller and buyers of IPO. Also, the document examines ways in which one can account for the success of the IPO market. Both seller and buyers encounter challenges in obtaining accurate market information due to various barriers causing information asymmetry. The availability of market information plays a crucial role in any market because it influences the behaviour of buyers.3 The information about price and quality of products and services enables the buyer to make a choice on what product to buy and at what price. However, the information about service is difficult to establish because of intangibility and concurrent production and consumption of services.4 The choice of what to purchase becomes severe due to the potential for dissimilarity in service and product quality and information asymmetry. Sometimes the search for market information is very costly and as such causes hindrance to the choices available for buyers to make.5 Not only the buyers who encounter challenges of obtaining market information, but also the sellers have inaccurate reliable information about the market. For example, the seller may want to understand the behaviour of buyers, the future market trends, economic conditions and so on. Both sellers and buyers hold different sets of information which affects their behaviour in the market.6 Therefore, different sets of information regarding price, quality, specifications, performance and circumstances of transfer affects the transactions and increase cost for both parties. Public offering and nature of market information IPO refers to a public offering that involves the sale of stocks of a private company to the general public for the first time, on a securities exchange.7 A private trading company converts into the public company after issuing IPO to the general public investors. A private company can issue IPO to the public for various reasons. They may do so to raise capital for expansion of its activities or just to convert the investments of private investors into money and become publically traded companies.8 Also, by going public, a private firm can enjoy a number of benefits effective management and ease of raising capital for expansion. However, there are some disadvantages associated with a publically trading company such as loss of control of business information.9 This is so because there is requirements that companies must disclose information about its financial account to the public to enable the public make informed decisions. Therefore, companies fear disclosing information to the public in order to minimize the risk. Private investors can encounter unique challenges because of inability to predict the stock performance when they start trading publically in the security market. The reason for this challenge is apparent because there is no historical data to help the investor in predicting the market performance of a newly listed company.10 Furthermore, companies issuing IPO are those going through transient growth hence are filled with uncertainties in regard to their future values. For a company wishing to be listed in the security exchange market, it must disclose its information of book of account to the public in the form of a prospectus.11 Such companies obtain the assistance of the underwriter to determine the price value of its shares and the initial sale price of the shares. The listed company is not required to return the capital contributed by the public investors.12 Those investors must tolerate the capricious nature of the open market to price and transact their shares.13 During the open market trading, the transactions take place in the secondary market offering between the public investors without involving the issuer. It is, therefore, essential for the investors to acquire as much information about the IPO issuer as possible in order to minimize the risk of losing the investment. The sale of IPO is of great significance to the economy and public investors. The annual value of IPO of a country is a measure of investors’ confidence in the country’s economy. As for the investors, IPO offers an investment opportunity for generating better returns than the interest rates offered by banks and investments in bonds.14 The recent offerings in UK include AA Motoring Group.15 During the recession, the IPO market shrunk to almost insignificant value due to lost investor confidence among other factors. However, the end of depression has seen a rapid increase in the value of IPO market in UK and other nations. For example, in the year 2014, companies raised about £13.6bn within the first five months compared to £3.6bn they raised during the same period in the previous year. Such increasing values demonstrate an increasing investor confidence and growing market economies. Companies such as Royal Mail and DX Group have performed very well in their IPO issue in 2014.16 However, there has been over surplus in other companies IPOs that have resulted in share price flip-flop and ensuing market jitters.17 Therefore, there is a need for investors to exercise much caution when making an investment decision on IPO market because there is no guarantee for success. Information asymmetry The UK Listings Authority requires all privately owned companies wishing to be listed in the security exchange market must disclose finance and business information to the general public.18 The information is critical because it ensure the investors have complete information about the company, the possible risk associated with such business and predict the company’s future performance.19 Although disclosure of such information could be detrimental to the respective enterprise, it is vital for the investors interested in committing their resources to buying the shares of that company. One of the major causes of information asymmetry in the IPO market is the exaggerated valuations carried out by the underwriters. For example, “Just Eat, a takeaway food ordering website backed by venture capital firms, valued itself at up to £1.47bn in anticipation of its stock market listing in March.”20 However, it later turned out that the company was overestimated about 100 times of its original earnings. On average firms yearn for 14 times their value.21 The information provided by the underwriters is not always accurate or timely to enable investors make a sound investment decision. Overestimating the company’s value during initial offering has direct adverse effects on the investors because the market price of the company is usually below the offering value or par value. A good example is the case of AO World which is a retailer of TV and Kitchen appliances.22 This company floated its shares in February and during the first day of public trading their value rose by about 33%. However, for the two subsequent months the shares have been trading at its below-listing price. Other similar companies selling at below their listing price include Saga, Bagir Group, and Pets at Home.23 Therefore, overvaluation of the share price of the companies is responsible for the imbalance of information between sellers and buyers hence affecting the investment decision-making. Apart from exaggerated valuations of the share price, investors rarely take the time to examine the listing companies before purchasing their shares. According to BBC, the problem is partially caused by rapid increase in the number of IPOs and partly due to the failure of IPO prospectus to provide timely information for decision-making.24 The requirement is that such information should be availed to the public six days before commence of official public trading. The increasing number of IPO listing companies creates challenges to the investors by making it difficult for them to spot valueless listing before they come to a conclusion on which company’s stock they can buy. Additionally, the IPO prospectus that offers detailed strengths and weaknesses of the company limits the interested investors on the accessibility of information for making an investment decision.25 Therefore, investors should raise concern regarding the actual cause for the current firm owners to make the decision to relinquish their ownership of the company to the public investors. Having such a concern is critical because it will make them desire to learn more about the company’s performance and possible future performance to avoid committing their resources to dud IPO listings. Another cause of information asymmetry between sellers and buyers of IPO is the influence of the advisors. The success of IPO listings is determined by the recommendations of independent advisory banks bestowed responsibility for advising both the firms and investors.26 The advisors are business partners interested in the success of the IPO because the returns increase with the success of the offer. It is obvious that investors want to buy the shares at least possible price.27 On the other hand, sellers want to fetch the best highest price they can afford for their stocks. Therefore, investors should avoid overreliance on advisors and become proactive in learning about the status of the firm.28 Since parties exaggerate the market price either way, there is an assumption the market mechanism will undergo self-adjustment and settle at equilibrium. Therefore, investors should avoid too much exaggeration that could have detrimental effect stocks returns after attaining equilibrium. Ensuring IPOs are successful A Successful Initial offering could mean the company has successfully sold the intended shares to the public at the best price.29 The shares should not be reducing in value when they get to the secondary market. The investors consider IPOs successful when and if the can get the stocks of target company at a fair value than what they expect to get in the secondary market. Furthermore, the shares should be difficult to sell in the secondary market when investors opt to sell to other public investors.30 Following the recent IPO losses during public trading investors have started exercising caution to avoid loss the stock value. Just as aforementioned, investors are becoming proactive to ensure they have the right information before making an actual investment decision. This has been demonstrated in the case a clothing retailer, Fat Face.31 The firm hiked the value of its IPO by more than £400m, but due to lack of investor interest the company had to scrap off the offerings. Another case was demonstrated by the Saga Company in which they had to list the value of IPO at the bottom of a price range following intense investor pressure. 32 The investments in IPO are based on speculation about a possible increase in market price of the stocks when they start trading publically.33 On one hand, investors will become keen on acquiring accurate firm’s information to minimize the loss that may be caused by declining market value of shares. On the other hand, companies will become more careful with the information they offer to ensure the success of the offering. This will be influenced by the increasing supply of IPO that will compel those firms seeking to raise money for expansion of their activities to offer a competitive price in order to attract investors.34 Despite all the shortcomings above both investors and companies can reduce the information gap by undertaking specific tasks as discussed. Investor Undertakings Read the prospectus Information about company’s performance is essential for the investors interested in purchasing IPO. The law requires any company interested in listing IPO in the public market to publicize information about its performance, risks and opportunities, as well as the proposed use of its funds after the sale of IPO.35 Accompany interested in expanding its investment activities through the sale of IPO presents an enterprising opportunity to individual investors. This is so because as the company expands its operations, so it expands opportunities for increasing income. The firms’ managers should be careful about the nature of promises they make to the investors.36 It is not good to promise what they cannot deliver. Promising what one cannot deliver has adverse effects on the promisor and promise. Investors should scrutinize the projected accounting figures with caution to establish any possibility of being overly optimistic.37 Just as earlier mentioned, the prospectus may not mean much to the IPO investors. Investors should not entirely depend on prospectus when deciding on IPO investment decision.38 The challenge with the prospectus is that it contains information provided by the firms wishing to trade its shares in the security market.39 They tend to provide information that will favour for listing in the public market. Therefore, since no unbiased third party is involved in writing the prospectus, an investor must approach such information with caution.40 It may contain some misleading information that favours the firm at the expense of the investors. Conduct Background Search of Information Investors can supplement prospectus with thorough background check about the company using the internet and other sources of information relating to the company.41 When conducting background check investors will be interested in obtaining information about the company’s nature of the industry. The bias should be on the company’s rival, industry trends, financial and previous press release.42 It may not be easy to obtain all the information about the company, but one should acquire much information they can. Furthermore, the investors should use the information they acquire from personal research and compare it what is in the prospectus.43 In so doing, the investor can establish quickly whether the company had made exaggeration in the prospectus or whether they offered accurate information. Additionally, the information is crucial because it enables investors to assess the current status of the company and predicting on the future performance. Investors are interested in information about the company’s competitors, short-term, medium and long-term investment goals.44 Also, they want to know how the company is handling issues of corporate social responsibility, how it is adhering to environmental regulations, employment policies, tax obligations and so forth. Where the company has no strategies for future growth or is not operating within the confines of the existing government rules and regulations, the investor may have to be cautious before buying its shares.45 Taking caution IPO market is based on speculations. There is uncertainty about the future outcome of the investments. Once the underwriter recommends a company go public, the managers should take time and re-evaluate their willingness and readiness to go public. They ought to examine the nature of economic conditions in order to determine their preparedness to go public.46 Also, they ought to evaluate the public perception about its offering. Furthermore, managers should assess the resources they have to stimulate the investor confidence.47 Other relevant considerations a firm should make is whether they have adequate capacity to stimulate long-term growth for shareholders. Finally, the firm managers should assess whether they are ready to bear the cost and regulatory requirements involved in going public. On the other hand, investors should establish the motive behind the proposed public offering and the chance available for them to secure investment in that company.48 Sometimes an investor can fail to make the targeted investment because the firm opted to preserve its IPOs for selected individuals. Examine the quality of company’s underwriters Underwriters are investment banks responsible for assessing the companies undergoing public listing and issuing recommendations to that company and the general public.49 Underwriters are interested in business partnership and can work in favour of the company to the detriment of the investors. However, well-established brokers or underwriters can give reliable information compared to emerging underwriters.50 It is worth noting that stable brokers will never allow first time investors to purchase an IPO because this is a preserve of long-standing established individual investors. Therefore, an investor can increase the chances of successful IPO offerings by going to the companies with well-established advisors. Obtain information from regulating authorities or agencies Finally, an interested investor can obtain records about the company’s performance from regulating bodies such as Financial Conduct Authority (FCA). This is an independent body responsible for regulating financial firms offering services to the consumers. The institution also maintains the integrity of the financial market in UK.51 FCA has powers to investigate the conducts of the company and their financial products. They set minimum required standards and product requirements. They can suspend or ban a firm from the financial market in case of non-compliance with the standard requirements. They can compel the company to modify a misleading advertisement and publish such resolution. They also regulate consumer industry to promote fair trading.52 Therefore, both investors and firms can obtain market information from governing bodies such as FCA to ensure successful IPO offering in the financial market. Company’s Undertakings Market Evaluation Various strategies are available for companies to address the issues of information asymmetry in the market. Such strategies are either regulatory or individual effort to close the information gap between the buyers and sellers. For example, the establishment of investor relations has reduced the barriers to access of market information between buyers and sellers in the security market.53 Investor relations refer to the continuing activity of companies sharing information with the public investors. The investor relations involve both voluntary and regulatory activities to ensure interactions between existing investors, potential investors and companies as well as the business analysts and journalist. Investor relations can occur in various forms such as meeting with investors, annual reports, company news releases and websites. Investor relations are a communication exchange where companies explain about their businesses to the investment community and obtain views and feedback of the audience.54 It is an on-going responsibility undertake by the companies to provide information to the investment community about the business hence closing the information gap and ensure successful investment plans.55 Through investor relations can raise the required capital since the interaction between companies and investors improves investor confidence and attracts more investors. Additionally, the investors’ relations enable companies to provide detailed records of their performances. This opens an opportunity of fair valuation of the company. Fair valuation allows the investors to obtain a clear view of company’s performance from the interested investors. Furthermore, such information will help the company to determine how the public is evaluating them. Such information will help the company to evaluate their expectations about the market and understand whether the public views about the company’s performance are in line with its own views.56 Therefore, interested investors can focus on investor relations to learn about the company’s performance, the companies goals and obtain the views of others about the business they are interested in buying its shares. Good Management Practices The company should be fair with the information they release to the public. For example, they should not inflate the price of shares or offer unattainable promises because such practices with influence the performance of company’s shares in the market.57 They should also have good reasons for selling shares and ensure good management strategies to win the confidence of the investors. Targeting Institutional Investors The company issuing IPO can ensure the success of the offering by targeting the key institutional investors. Institutional investors are the most dominant owners of UK equity market.58 They are of significant importance in the market owing to the bulk of assets under their management. In some cases, institutional investors can purchase nearly all share capital issued by a company.59 Furthermore, institutional investors have long-term investment goals hence they commit finances in long-term ventures. Therefore, a firm can ensure the success of its IPO by targeting institutional investors because they provide capital for long-term investment thus giving the managers an opportunity to implement its strategic goals.60 Of course, this makes sense because most of the IPOs fail because some investors targeting quick income get frustrated when such income does not come as they expected. Out of frustrations, they opt to sell their stocks at whatever price to recover their money.61 Consequently, this results to an oversupply of the stock in the market leading to a drastic drop in market price of the shares. Conclusion The success of the IPO offering does not only stable investment opportunity for the investors, but it also implies continuous returns for the company. It determines the effectiveness with which the company can attract and retain investors and the future value of the company’s shares in the market. A successful IPO should translate into the higher market value of the company’s stock. If a company is performing well in the security market, it attracts secondary investors and qualified team of managers resulting in continued operation. Therefore, it is in the best interest of both investors and managers of the company to have successful IPO listing in order to experience improvement in its performance. The information asymmetry is the main impediment for success IPOs. However, companies overcome such asymmetry by obtaining the prospectus from underwriters, through investor relations, targeting potential investors offer a fair price and by being truthful with the information. On the other hand, investors should get as much information about the company possible. They should be aware of the reasons for the sale of shares, assess the performance of the selling company, the industry of the company and any other information that could affect the business performance. Therefore, they need to be careful when selecting the company, read the prospectus and carry out background search about the company. List of References Books Bauman, Jeffrey D., Palmiter, Alan R., Weiss, Elliott J. & Partnoy, Frank, Supplement to Corporations Law and Policy: Materials and Problems, (Thomson/West, 2004):  90. 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