Asymmetric Information, Signaling and the Initial Public Offerings of Internet Firms
Arun Sundararajan
Abstract:
The initial public offerings (IPOs) of 'Internet' companies are priced at a significant discount, relative to their market price on the first day of trading. Furthermore, their underpricing is significantly higher than the well-documented industry-wide average IPO underpricing that has been previously observed. This study attempts to explain why this is so. It is theorized that in nascent and rapidly evolving industries such as those characterizing Internet firms, there is true information asymmetry prior to the public offering: that is, both the owners of the firm, and all the potential investors are not fully informed about the expected cash flows of the firm. The investors' lack of information is a consequence of their incomplete knowledge of the quality of technology owned by the firm, while the firm's owners may not have complete knowledge of the cash-flow generating potential of the type of technology and business model that they base their firm's future on, and use the IPO partially as a mechanism to get this information from the market. The post-IPO price therefore also forms a immediate input to the firm's subsequent corporate strategy.
This idea is modeled as a signaling game, and initial results indicate that, among other things, even if the systematic risk of the cash flows from the technology are known, and the degree of underpricing does not form a signal of the firm's technological competence, that there will be significant underpricing of the IPO, and that the level of this discount is positively related to the uncertainty associated with the type of technology owned by the firm. Some preliminary empirical support for the model is also discussed.
Business Week article
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