Abstract
AbstractRitter [14] documents that best efforts IPOs are, on average, more costly to issue than firm commitment IPOs. This paper explains the phenomenon. Two component costs of going public are analyzed: underpricing and underwriter compensation. The model, based on a disagreement about firm value between underwriters and issuers, shows that underpricing is higher for firms using best efforts contracts as these firms, on average, are more speculative. Underwriter compensation is hypothesized to be higher for firms using best efforts contracts because of the high costs of market making for these firms in the aftermarket and the high distribution costs associated with the high risk of a failed offer. Empirical tests strongly support the propositions.
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