Security Design in Initial Public Offerings

Abstract

We investigate an IPO security design problem when information asymmetries across investors lead to a winner's curse. Firms that are riskier in down markets can lower the cost of going public by using unit IPOs, in which equity and warrants are combined into a non-divisible package. Furthermore, firms that have a sizeable growth potential even in bad states of the world can fully eliminate the winner's curse problem by making the warrants callable. Our theory is consistent with the prominent use of unit IPOs and produces empirical implications that differentiate it from existing theories. Abstract We investigate the security design problem in an initial public offering (IPO). In line with Rock (1986), we consider a situation in which some investors are better informed than others about the prospects of the firm, resulting in a winner's curse problem. To raise capital, the owners of the firm must underprice the securities they issue in order to compensate the less informed investors for their willingness to participate in the issue. In this context, we first show that firms can sometimes lower the cost of going public by using unit IPOs, in which equity and warrants are combined into a non-divisible package. Because warrants are less sensitive to low cash flow realizations, unit IPOs tend to be valuable to firms that face large downside risks or whose uncertainty revolves around the eventual performance of their assets in place. Second, we show that firms may be able to completely eliminate the winner's curse problem by making the warrants callable. Such a first-best scenario is possible when a firm's growth potential is sizeable even in bad states of the world, as the callability feature of the warrant allows the firm to dynamically create payoffs that are insensitive to the investors' private information. Our theory is consistent with the prominent use of unit IPOs and produces empirical implications that differentiate it from existing theories. * We thank Roger Edelen, Alex Edmans, Richard Kihlstrom, Marco Pagano, Christine Parlour, Uday Rajan, Oded Sarig, and an anonymous referee for their comments and suggestions. Also providing useful comments and suggestions were seminar participants at Baruch College, the University of Kentucky, National University of Singapore, York Security Design in Initial Public Offerings AbstractWe investigate the security design problem in an initial public offering (IPO). In line with Rock (1986), we consider a situation in which some investors are better informed than others about the prospects of the firm, resulting in a winner's curse problem. To raise capital, the owners of the firm must underprice the securities they issue in order to compensate the less informed investors for their willingness to participate in the issue. In this context, we first show that firms can sometimes lower the cost of going public by using unit IPOs, in which equity and warrants are combined into a non-divisible package. Because warrants are less sensitive to low cash flow realizations, un...

A story on SPACs

“…Chemmanur and Fulghieri (1997), believe that unit IPO solves the information asymmetry problems and enables companies that are considered risky by outsiders, to signal their true value. Chakraborty et al (2011) provide theoretical explanation for the possibility of the lack of underpricing in unit IPO. They find an optimal ratio of stocks and warrants in a unit.…”