Determinants of Price Premiums: A Study of Initial Public Offerings in the Medical Diagnostics and Devices Industry

Abstract

Initial Public Offerings (IPOs) represent a common way by which emerging firms finance their growth. This is especially true when the resources required for such growth can neither be provided by the entrepreneurs nor secured through debt financing due to increased costs and risks associated with higher levels of debt. The active market for initial public offerings (IPOs) in recent years has raised several issues. For example, initial returns exceeding 200 percent for IPOs of companies such as Boston Chicken and Netscape have sparked considerable interest in IPO pricing. Such extraordinarily high returns to investors immediately after the IPO seem to suggest that in a number of cases IPOs are priced at a significant premium over their book value. This leads to the obvious questions, Why do some IPOs command a high premium over book price while other do not? What factors are responsible? These questions have important implications from the perspective of the issuer who has a self-interest in maximizing the share price. This study addresses the issue of IPO pricing and investigates the factors that influence the price premiums in initial public offerings. Because industry conditions are likely to influence IPO pricing and price premiums, we control for industry effects. We focus on IPOs in a single industry - the medical diagnostics and devices industry. This industry has been characterized by significant change and a relatively large number of IPOs. This article is structured as follows. In the next section, we discuss issues related to IPO motivations, pricing, and price premiums. We also discuss the factors likely to influence price premiums and identify the specific hypotheses examined in this study. In the next section, we discuss the research methodology, including sample identification and selection, measures, and the analytic technique adopted. In the final section, we present the results, discuss the implications, and suggest possible directions for future research. Theoretical Overview and Research Hypotheses IPOs: Motivations, Pricing, and Price Premiums What motivates the decision to go public? The literature suggests several factors. A public offering provides a firm the resources required to pursue aggressive growth strategies. Since an IPO increases the amount of equity, it also enables the firm to borrow more. An initial public offering gives the firm an excellent opportunity to restructure its balance sheet. Once the shares are publicly traded, the firm can acquire new businesses by issuing new stock to the sellers (James 1989). A public issue also brings greater name recognition to the company. Moreover, the company may be able to motivate and retain high-quality management by initiating stock-compensation plans (Lauer and Zeune 1987). Besides these benefits to the firm, a public offering also provides benefits to the individual owners. First, it provides the owners a more liquid investment. Second, it aids in the estate planning of the firm's principals (Steck 1984). Third, it is a way to answer the dream of becoming wealthy. The story of Bill Gates becoming a billionaire overnight as a result of Microsoft's IPO is the stuff of legend (Uttal 1986). In addition, going public also feeds the desire to become the CEO of a publicly-traded corporation (Young and Zaima 1988). At the very least, going public provides a means for entrepreneurs to harvest and venture capitalists to exit from their investments (Timmons 1985). Overall, an IPO can be viewed as an event shaped by the motivations, decisions, and actions of three sets of players: the issuer, the underwriter(s), and the investors. They are guided by different and, often conflicting, sets of objectives at the time of an IPO. For example, issuers like to maximize the offering price per share to enhance their returns. In contrast, investors would like the lowest offering price, so that they can earn above-market returns when they subscribe to the issue. …