This article explains the reasons and motivations behind IPO underpricing. The understanding of these mechanisms can assist issuing companies in making strategic decisions regarding pricing during their IPO process.
Published:
March 16, 2022
Updated:
May 10, 2023
On Tuesday night, the day before its IPO, DoorDash settled on an IPO price of $102 per share. This was up from the company’s initially stated range of $90 to $95. When the stock started trading Wednesday morning, it started trading above the asking price, at $182. The stock price closed the day at $189.51. In other words, the share price closed after going up 85% from the initial asking price. This type of “first-day pop” in stock prices isn’t unusual. It is so common, it has earned its own widely recognized financial term: IPO underpricing.
Over the past several decades, IPO underpricing has remained a consistent trend in the financial market. One study in 2011 found that “over the last 50 years, I.P.O.’s in the United States have been underpriced by 16.8 percent on average” (Solomon, 2011). This trend has continued in recent years. The purpose of this article is to attempt to define IPO underpricing, summarize the research that has been done to explain why IPO underpricing persists, and discuss ways in which companies have attempted to control IPO underpricing.
What Is “IPO Underpricing?"
IPO underpricing refers to the situation in which an IPO stock closes at a higher price at the end of the first day of trading than the initial offer price.
Why are IPOs Underpriced?
Because of the complexity of the IPO market, there is no one explanation for IPO underpricing. Rather, researchers have spent years investigating different theories as to why IPO underpricing occurs. It would be impossible to cover the breadth and depth of the veritable sea of research that has been done in this short article. However, this article will highlight the main theories behind underpricing.
I. Information Asymmetry
Two of these theories are based on information asymmetries; in other words, the differences in information between the issuer and the investors.
The first is the theory of information disparities. This theory assumes there are more uninformed investors than informed investors. Informed investors only bid when they are certain they can get returns, but uninformed investors bid randomly and often lose money. As a result of constant losses, uninformed investors stop bidding. However, since the underwriters’ success is linked with higher demands, the underwriters need uninformed investors to continue to bid. Underpricing is used in this case as a strategy to cut the losses of uninformed investors and motivate them to keep bidding.
It is found that underpricing is often lower when information about the issuing company is more readily available.
The theory of information revelation is the idea that underpricing is used to compensate potential buyers for revealing accurate information regarding the price they are willing to pay. This theory is based on the underwriters’ book-building process. As the underwriters collect bids from different potential buyers, they collect information on what price the market is willing to pay. To motivate potential buyers to disclose accurate information on what price they value the issuing company at, the underwriter allocates fewer shares to the lower price bids and discounted shares to the high bidders. This discount is another cause of underpricing.
II. Agency Conflicts
An agency conflict happens when one party is given the responsibility to act in the best interest of the second party, but conflicts of interest arise.
In the case of IPOs, one theory is that underpricing is costly for the issuing company, but it benefits the underwriters and the potential investors. Underpricing creates a larger demand which translates to a higher volume sold and therefore larger commission fees for the underwriting bank. Underwriters are expected to act in the best interest of the issuing company, but this conflict of interest motivates the underwriters to underprice for their gain.
Higher IPO commissions have been found to reduce this motivation for underpricing. In addition, if an underwriting bank earns a reputation for incorrectly pricing companies, they lose chances for future IPOs.
Another theory under agency conflict is the managerial conflict theory. In this case, the management of the issuing companies wants to ensure their ability to sell their shares at a higher price after the contractual lockup period. Since the management of the issuing company has large control over the IPO price, this can motivate underpricing. The management team may also underprice to attract more investors, creating diversity in shareholders. This decreases the chances of having dominating shareholders who could decide to replace the current management of the company.
III. Publicity
Another theory for underpricing is as a ruse for free publicity. Historically, deeply underpricing stocks have made front-page news. In the case of LinkedIn, they lost more than 100% as the stocks rose rapidly on the first day of trading. This drastic underpricing received national news—free publicity for their website equivalent to potentially tens of millions of dollars. Additionally, LinkedIn only sold less than 10% of their company at this underpriced value in their initial IPO. In the end, the company gained much more than it lost.
IV. Legal Issues
Legal liabilities and bad publicity may also be a motivation for underpricing. In almost every case of overpricing, there are lawsuits. Overpricing is the opposite of underpricing—where the issuance price is higher than the fundamental value, or value after going public. In 2012, Facebook’s stock fell lower than the IPO price within their first few days of going public. More than 40 lawsuits were filed against them within the first month. Facebook ended up paying out a $35M settlement due to a class-action lawsuit accusing the company of nondisclosure of their future growth worries before their IPO. Underpricing is often less costly than overpricing, especially in public image. This rationale and the desire to avoid legal issues and bad public image can be another contribution to the trend in underpricing.
Can Companies Control Underpricing?
The short answer is probably not—at least not entirely. In some cases, underpricing may even be desired. By evaluating individual situations, following the best practices, and understanding the motivations in this article, issuing companies can do their best to avoid major pitfalls and losses.
Resources Consulted
https://www.cnbc.com/2020/12/09/doordash-ipo-dash-trading-nyse.html
https://www.managementstudyguide.com/why-do-ipos-get-underpriced.htm
https://dealbook.nytimes.com/2011/05/27/why-i-p-o-s-get-underpriced/
