The Seller's Curse and the Underwriter's Pricing Pivot: A Behavioral Theory of IPO Pricing

Abstract

Canonical theories of law and economics predict that issuing firms in initial public offerings (IPOs) demand — and that competitive markets produce — a transaction structure that maximizes value to issuers. Yet, since 1980, corporate America has left approximately 19 cents of foregone proceeds on the table for every dollar it has raised in IPOs. Moreover, the standard IPO contract appears designed to exacerbate rather than resolve agency costs, information asymmetries, and other foreseeable causes of IPO underpricing. This Article studies a new puzzle: why don’t issuers anticipate their transactional vulnerability and bargain for a sale of stock contract that protects them against foreseeable causes of underpricing? To explain this puzzle, I model issuer heterogeneity in a novel way. Some fraction of issuers have managers that — when they engage an underwriter months before the IPO — fail to anticipate their underwriters’ incentives or capacity to impose underpricing when the IPO is priced. The interaction between market forces and managerial psychology at these naive issuers explains the structure of the standard IPO contract. Conditional on using the standard IPO contract, underwriters pivot between two strategies. In the IPOs of naive issuers, underwriters hold up and underprice IPOs. In the IPOs of sophisticated issuers, underwriters short sell the issuing firm’s stock and overprice IPOs. The model predicts efficiency losses and wealth transfers from naive issuers and one-shot investors to underwriters, repeat investors, and sophisticated issuers in IPO markets. The behavioral theory I present provides a more comprehensive explanation for IPO pricing and practices than existing accounts, and supports arguments for substantive reforms to federal broker-dealer regulation.