Course Number: FIN501 Module 1 Case Assignment Introduction Upon deciding to go public, a company looks into preparing an initial public offering (IPO). There are two IPOs with which a company can utilize: a traditional IPO or the relatively new Auction-based IPO that was made popular by Google. Avaya is currently planning for IPO. “Avaya is a global leader in business communications systems.
The company provides unified communications, contact centers, data solutions and related services directly and through its channel partners to leading businesses and organizations around the world” (Avaya. com, 2011). Avaya’s current plan of an IPO valued at approximately $1 billion (Klassen, 2011) needs to consider whether to go with a traditional IPO or Auction-based IPO. While Google and Morningstar had success with Auction-based IPOs, due to a lack of investor knowledge into the value of the company Avaya should conclude on a traditional IPO.
Advantages, Costs and Risks of Each Type of IPO Traditional IPO When a company choses to go with a traditional IPO, they hire an investment bank to underwrite, or “the process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt)” (Investopedia. com, 2011), the IPO. Once a bank has been chosen to underwrite the IPO, the company and bank research a likely market value of the company.
Then based on this research and amount of capital the company is looking to raise in the IPO, the company and bank determine the number of shares to be offered as well as the price of each share. The price determined here is commonly reduced from the true market value the company and investment bank estimated it will be. Next is the road show tour where the offering is presented to large investors, normally the investment bank’s top clients which include institutional investors or wealthy individuals.
Those who are interested in buying shares at the offered price will commit to the number they want during this time. The investment bank and company review all the commitments after the tour and allocate shares to investors, which may not be the amount they committed to. Once this process has finished, the investment bank is paid a percentage of the sale as commission as well as fees for the underwriting process. Due to the discount of the IPO from the estimate of the market value, traditional IPOs normally trade much higher than the initial price (Clinton, 2011).
Being a long used and well known process, traditional IPOs allow for more choices of underwriters. Using an investment bank with experience in traditional IPOs allows for the road show to give the high profile investors a greater idea of the value of the company, and since the allocation of shares is done during this process they can avoid over-valuing the company. Nayantara Hensel writes that underwriters who do less than three IPOs a year will average a first day price increase of 10%.
On the other hand Hensel also tells us that the average first day price increase for all traditional IPOs is 38%, meaning a loss in the potential capitol for the company. The investment bank underwriting for a traditional IPO normally gets a 7% underwriting fee of the amount earned or more, bringing the potential money lost to 45-50%. Auction-Based IPO An auction-based IPO uses the Internet to open a company’s IPO stock for purchase to more potential investors. This process allows a company to spend less on their underwrite fees.
The company determines how many shares they will be offering along with a reserve price. They may choose to do a road show in order to educate larger investors about the company, but they do not allocate shares during this time. Once bidding in the auction begins, investors have the opportunity to enter a bid for the number of shares and price they want to buy them for. These auctions normally use a Dutch auction format, where the company sets a price above what they expect any investor to bid and incrementally reduce the price until someone bids.
After the bidder is sold their number of shares, the price continues to drop until all of the offered shares have been sold. The price paid by the final bidder is the price that all previous bidders pay (Clinton, 2011). Smaller companies often find auction-based IPOs to be enticing because of the lower fees involved and the likelihood that the share price will be closer to market value is greater, which means the company made more of the profits than the investors on the first day of trading (Clinton, 2011).
While Auction IPOs average only a 29-30% price increase in the first day of trading (Hensel, 2009), there are fewer underwriters to choose from as many banks do not participate in Auction IPOs. This does not allow for the optimal price in underwriting fees for Auction IPOs, although due to the decrease in work for the underwriter a fee of 4-6% is normally charged. The downfall to this is loss of positive press the company would receive for the substantial increase in stock price on the first trading day, losing valuable publicity opportunities.
There is also the risk of a company overestimating their value and raising less capital than they expected (Clinton, 2011). Investors Avaya is Likely to Attract Being a global leader in business communications with a strong hold in the market, they hope this will bring success when they go public. When they do, Avaya is not likely to appeal to the average and unknowledgeable investor. Having a foothold in the business industry for communications leads one to believe that higher profile investors and companies will be the only investors to truly know the value of buying shares of the IPO.
Using an Auction-based IPO will cause the average investor to hurt the price of the IPO by not knowing how much it should be worth. Lessons learned from Google and Morningstar’s auction IPOs Google brought popularity to the Auction-based IPO when the company went public on 2004, followed by Morningstar in 2005. The opening price on the day of trading of Google’s IPO was $85, jumping immediately to $100. The $85 is below the $108-$135 per share Google had valued their company at (Shread, 2004).
Lack of a road show with high profile investors didn’t allow them the insight to properly evaluate their value and caused them to look for more than investors were willing to pay. Morningstar’s Auction-based IPO went more smoothly, selling 8. 75 million shares at approximately $18. 50. “The auction detractors argue that because winning bidders in the Morningstar auction received only 65% of the number of shares they bid for, Hambrecht set the IPO price low enough to ensure the stock price would rise once trading began – just as big Wall Street firms attempt to do” (Smith, 2005).
Conclusion Looking into preparing an IPO, companies need to decide whether to use a traditional IPO or Auction-base IPO. While Auction-based IPOs have their advantages, traditional IPOs are still the standard method for a reason. While Google made the auction method popular and Morningstar had success with an Auction-based IPO, due to a lack of investor knowledge into the value of the company Avaya should conclude on a traditional IPO. References Avaya. com. (2011). About Avaya. Retrieved from http://www. avaya. com/usa/about-avaya/ Clinton, L. 2011). Traditional IPO vs. Auction-based IPO. Retrieved from http://www. essortment. com/traditional-ipo-vs-auction-based-ipo-24886. html Hensel, N. (2009). An empirical analysis of the efficiency of online auction IPO processes and traditional IPO processes. International Journal of Managerial Finance, 5, 268-310. Retrieved from http://proquest. umi. com/pqdweb? index=0&did=1882723331&SrchMode=1&sid=1&Fmt=6&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1294956905&clientId=29440 Investopedia. com. (2011).
Underwriting. Retrieved from http://www. investopedia. com/terms/u/underwriting. asp#axzz1cmrQZup0 Klassen, M. (2011). REPORT: Avaya Planning to Go Public. Retrieved from http://www. thetelecomblog. com/2011/06/08/report-avaya-planning-to-go-public/ Shread, P. (2004). Google’s IPO Jumps to $100 at Open. Retrieved from http://www. internetnews. com/bus-news/article. php/3397291/Googles+IPO+Jumps+to+100+at+Open. htm Smith, R. (2005). Why IPOs Still Use the Old Way. Retrieved from http://www. wrhambrecht. com/about/media/20050706wsj. pdf