In an article I published a couple of years ago with my colleague Stan Fawcett, we surveyed 336 chief financial officers about their perceptions of the initial public offering process. The academic article is published in the Journal of Finance, February 2006 issue.
We surveyed three types of CFOs: those who had recently completed an IPO, those who had recently withdrawn an IPO attempt and those who had never tried to conduct an IPO.
We asked the CFOs a series of questions based on academic theory. Often, university professors are accused of living in ivory towers and not paying attention to the real world. This study was an attempt to listen to those who actually conduct the affairs of firms.
The CFOs shared some interesting insights. We first asked about the motivation for conducting an IPO. Financial theory would suggest most companies don't consider an IPO until they have run out of cheaper financing. If a company could use cheaper retained earnings or debt, theory argues, it would. But instead of agreeing with this conventional academic theory, the CFOs indicated that the primary reason for conducting an IPO was to participate in the mergers and acquisitions market.
When we started our research, we thought that firms wanted to go public so they could create a public share price and thus sell out at a higher price. Examining the frequency of mergers and acquisitions completed by the issuing IPOs, however, indicated that many more firms conduct an IPO so they can become acquirers, not targets.
This result was surprising at the time. However, there are now several academic studies that verify this finding.
Another interesting result of our research was learning that CFOs are aware of the concept of under-pricing and are well-informed about the level to expect. Under-pricing is when the offer price is lower than the first day's closing price. Historically, the level of under-pricing has been about 18 percent.
You may recall the Google IPO, in which they used an auction system of pricing the IPO. The hope was to avoid under-pricing. Google was under-priced and still had a positive run-up.
Selling founders often get upset if money is left on the table because of under-pricing. Academics have created dozens of theories on why IPOs are under-priced. When we asked the CFOs what they thought, and they indicated that under-pricing compensated investment banks for taking the risk of the offering.
In reality, investment bankers take very little risk when they underwrite IPOs, so the 18 percent seems high to us. But obviously, CFOs are willing to sacrifice the upside to the underwriters to complete the deal.
Although there were many other interesting results from our research, the last one I'll discuss here is how CFOs viewed signaling. Academics have created complex signaling models that rely heavily on advanced mathematical modeling. We hoped to see which of these models aligned with CFO perception. But CFOs felt the strongest positive signal was historical earnings, and the second-strongest positive signal was using a prestigious underwriter.
CFOs felt the strongest negative signal was when insiders sold shares in the IPO. When insiders sell shares in the actual IPO and don't wait until after the lockup, investors may reason the insiders are dumping over-valued shares.If you would like to learn more about what CFOs think about the IPO process, the full citation to my academic article is: "Initial Public Offerings: An Analysis of Theory and Practice," Jim Brau and Stan Fawcett, Journal of Finance, Vol. 61 (February) 2006, pp. 399-436. The citation to a practitioner piece I wrote using the same data is: "Evidence from What CFOs Think about the IPO Process: Practice, Theory, and Managerial Implications," Jim Brau and Stan Fawcett, Journal of Applied Corporate Finance, Vol. 18, No. 3 (Summer) 2006, pp. 107-117.
Jim Brau is affiliated with the BYU Center for Entrepreneurship. He can be reached via e-mail at [email protected].