Pursuing Value Through Liquidity: Share Retention, Lockup, and Underpricing in IPOs

Abstract

This paper proposes that in an initial public offering (IPO), pre-IPO owners make decisions regarding share retention, share lockup, and underpricing to improve liquidity, which in turn increases the value of shares they retain. We suggest that underpricing will increase the number of investors following the stock and foster more trading in both the short run and the long run. Liquidity is negatively related to the proportion of shares retained by pre-IPO owners, ceteris paribus, so we predict that IPO underpricing is positively related to the proportion of shares retained, as an offset. Our predictions are supported by empirical evidence. In addition, we find that, for IPOs with a lockup restriction, underpricing is more substantial and the positive relation between share retention and underpricing is much stronger. We also explore the relation between underpricing and aftermarket trading volume. We find that the relationship between underpricing and trading volume is stronger for IPOs with lockup. IPOs with lockup have higher trading volume, and a significant part of this difference is associated with the effect of underpricing. The evidence supports the argument that for IPOs with lockup, underpricing improves liquidity more effectively; thus its use is more closely associated with share retention.