4. Choosing Your Investment Banker 30

Valuation and pricing issues
You may be most concerned with two underwriting functions in particular: valuing your company and setting a stock price. Valuation and pricing issues can involve a significant amount of time for both the underwriter and management and can havemultimillion-dollar implications. Although there is no standard formula, certain factors are always included in the valuation process. First, the underwriter must consider the condition of the market as a whole at the time the IPO is undertaken. Second, the final price will reflect the demand generated as a result of the “road show,” the period when your company and underwriter will try to generate interest in the offering.
Prices of other successful and similar offerings will also come into play, as will your company’s projected earnings and cash flow at the time of the offering. Price/earnings ratios and return on sales of other companies in your industry may be used to extrapolate a price for your stock.
Finally, the underwriter will consider a host of other, more subjective factors: expected growth; recent prices paid by sophisticated buyers in private transactions; inherent risks of the business; the company’s stability; and theafter-market trading objectives.
Taking all this into account, the underwriter will most likely choose a slightly lower price than the estimate. This is to guard against a weak after-market and to give buyers an incentive. Major-bracket underwriters generally prefer a price range of $10 to $20 per share. Underpricing or overpricing occurs when the first trades
of the newly issued stock trade above or below the offer price. Underpricing tends to be more persistent than overpricing, according to certain studies. This underpricing, if it is modest, has some arguable merits, i.e., after-market support, rewarding investors for taking a risk on the IPO, and — provided the market price holds or continues to increase — enhancing the possibility of a successful secondary offering.
There are a variety of theories as to why underpricing exists. One theory suggests that underpricing creates a high enough return so that even lower quality
issues can be fully sold; another considers the phenomenon a reflection of the underwriter’s incentive to avoid legal liability and reputational damage.
Perception is part of what makes pricing tricky. Selling five million shares of stock at $5 a share or two million shares at $12.50 will raise the same amount of money — $25 million — but a lower per-share price can negatively influence an investor’s sense of the offering’s quality and an underwriter’s desire to participate in the offering.
You must realize and keep in mind throughout the pricing process that your underwriters are faced with a tricky job. They must balance the pricing in such a way that neither the company nor the investor comes away totally thrilled — since one party’s pleasure comes at the expense of the other party. Underwriters like to say they will attempt to maximize the offering price to the company and provide a reasonable return to investors.

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