Why do underwriters underprice

So, to keep them safe from such a misstatement or omission, the issuer and the underwriter intentionally underprice the IPO. This makes sure that even if there is any failure or failures on the part of the issuer or underwriter, the buyer does not get to benefit from it as these are already priced in the IPO.

Even though underpricing is an important IPO concept, as we said above, it is for the short term. Once the stock — overpriced or underpriced — lists on the exchange, the demand and supply factors quickly bring it to its fair value. He is passionate about keeping and making things simple and easy. Running this blog since and trying to explain "Financial Management Concepts in Layman's Terms". Save my name, email, and website in this browser for the next time I comment.

What is Underpricing? Table of Contents What is Underpricing? Help us make this article better. Related Posts. If the price of shares is sold below the market price, then the investment banker has a higher probability that they will be able to sell all the shares easily. However, if the issue is fairly priced, there is always a chance that all the shares might not be sold off at once. Hence, pursuant to the underwriting clause, the investment bank will have to hold on to some of the shares on their books.

This would mean that their own capital gets locked, and they have to undertake the risks. This is the reason that investment bankers deliberately underprice their shares. Investment bankers have been arguing that this is incorrect. This is because it is not true that they hold a monopoly over the underwriting of shares anymore.

Ever since the Glass Steagall Act has been repealed, commercial banks, foreign banks, and a wide variety of institutions have the ability to underwrite shares. Hence, the competition amongst various underwriters should ideally eliminate the underpricing of shares.

The regulations related to securities issues in many countries make the investment bankers liable for any type of misinformation and the financial losses arising from the same. Hence, if it is proven in court that the investors were sold an overpriced issue, the investment bankers could face a huge liability.

Hence, they deliberately lower the valuation and keep a spread for themselves and underprice the shares. Determining the offering price requires a consideration of many factors. Quantitative factors are considered first. Those are the numbers, real and projected, on cash flow.

Nevertheless, there are two opposing goals at play. The company's executives and early investors want to price the shares as high as possible in order to raise the most capital and reward themselves most lavishly. The investment bankers who are advising them may hope to keep the price low in order to sell as many shares as possible since higher volume means higher trading fees for them.

The process mixes facts, projections, and comparables:. In theory, any IPO that increases in price on its first day of trading was underpriced, whether it was deliberate or accidental.

The shares may have been deliberately underpriced to boost demand. Or, the IPO underwriters may have underestimated investor demand.

Overpricing is much worse than underpricing. A stock that closes its first day below its IPO price will be labeled a failure. An IPO can be underpriced if its sponsors are genuinely uncertain about the reception that the stock will receive. After all, in the worst case, the stock price will immediately climb to the price that investors consider that it's worth. Investors willing to take a risk on a new issue are rewarded. The company's executives are pleased. That is considerably better than the company's stock price falling on its first day and its IPO being blasted as a failure.

Whether it was underpriced or not, once the IPO debuts the company becomes a publicly traded entity owned by its shareholders. This theory posits that the underpricing is because of American securities laws that impose strict liability on the issuer and underwriter for material misstatements and omissions made in connection with the I. The underwriter deliberately underprices the I. This theory has not found much support primarily because regulatory schemes in other countries are much laxer yet I.

These theories have gained attention in the wake of the technology bubble. One form of this theory posits that either institutional investors or managers gain from taking advantage of retail shareholders who act irrationally or otherwise against their economic interests. And that both institutional shareholders and managers therefore underprice I. A variation of this theory posits that it is the institution that allows this underpricing as a result of its own inability to recognize the loss. And these are but a few of the competing theories for I.

They may explain I. Sorkin discusses some reasons why this may be appropriate, including a need to show a successful I. These may be the reasons, or perhaps Mr. Nocera is right. But I have my own theory that overlaps a bit with Mr. But this assumes that there were enough investors willing to buy shares at that level. Now, LinkedIn can wait and sell shares later at this higher price, gaining more money in the aggregate.

The company, meanwhile, received national publicity for its Web site, something that may be worth the tens of millions of dollars alone, if not more.