Edited by Ben L. Kedia and Subhash C. Jain
Chapter 6: Information asymmetry and underpricing: the impact of innovation strategy and underwriter mediation
Becoming publicly traded is a big step in the life of a new venture and it allows the firm to raise capital for future growth. However, an unfortunate downside to the initial public offering (IPO) is that the new venture often leaves quite a bit of capital ‘on the table’ through underpricing. In a typical IPO, a new venture floats its shares of stock through an underwriter. The underwriter offers the shares to a group of institutional investors and any leftover shares are sold on the market on the first day of trading. Underpricing occurs when the difference between the offer price of the new venture’s stock, the amount of capital raised by the IPO firm, is less than the value of the firm (its closing price) on the first day of trading (Loughran and Ritter, 2004). The issue of underpricing remains an interesting enigma for both entrepreneurship and finance scholars. Understanding why it occurs can help firms maximize the capital raised, which may lead to greater performance following IPO. Rock’s (1986) theory of information asymmetry suggests that a lack of information about an IPO can lead to underpricing because of the ex ante uncertainty, cognitive limitations or bounded rationality. First, in the ‘winner’s curse’ model, Rock (1986) posited that some investors may be perfectly informed about the value of the IPO while others are uninformed.
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