Raising Entrepreneurial Capital

on the table.’’ The company could have sold far fewer shares at $50 than it

did at $15, thus not diluting its ownership in the post-IPO firm as much.

Some IPO buyers tend to be ‘‘flippers.’’ Flippers are institutional investors

with no intention of taking a buy and hold strategy in the company’s stock.

Rather, these investors bank on the observed average underpricing to create a

large first-day return as they buy low from the investment banker and sell

immediately to another investor in the secondary market. In effect, the insti-

tutions are low valuing purchasers of the stock. If the investment ban k sells

initially at the IPO price to these low valuing users, they can count on them to

immediately sell their shares to higher valuing buyers. This flipping generates

commission income for the investment bank. A higher valuing user buying at

the low IPO price would be inclined to hang onto the stock for the long term,

generating no commission revenue for the investment bank. Research shows

that the average trade size immediately after the IPO is 3,500 shares. One

month later, the average trade size has fallen to 2,000 shares.

14

OPEN IPOs

In traditional IPOs, the road show allows the underwriter to assess the

demand for the stock. Even so, as the average underpricing of close to 16%

illustrates, the price is not usually reset to balance supply and demand. In

oversubscribed issues, shares are allocated to the investment banker’s best

customers. Small investors have no chance to participate in ‘‘hot’’ IPOs. In

response to this failure to let the market set the price, investment banker

William Hambrecht left his investment banking firm of 30 years, Hambrecht

and Quist, to start a firm employing what he saw as a better and fairer

method of selling IPOs.

W.R. Hambrecht and Co. pioneered the open IPO in 1999. The open IPO

uses what is known as a Dutch auction process to clear the market for

shares. Buyers submit bids indicating the price they are willing to pay and

the number of shares they would buy at that price. Typically, the buyer

posting the highest bid is not willing to buy the whole issue, so the price falls

until the shares demanded equals the number of shares in the issue. Every

buyer pays the market-clearing price, and the issue is sold at the highest price

the market will bear. No money is left on the table, and all bidders are

treated equally.

An example (Table 7.2) will help illustrate the Dutch auction process.

Assume NewCo wants to issue 2 million shares in an IPO. The following

14

Woodward, Susan, ‘‘Auction-Based IPOs Eliminate Yet Another of the Market’s Biases,’’

Red Herring, December 1999.

254 Exit Strategies