IPOs and Information Cascades
There comes a point during every company’s lifetime at which it must decide on either staying private or going public. Though there are, undoubtedly, perks for remaining private, the incentives for going public are irresistible to many. A company goes public by means of an Initial Public Offering (IPO), through which they earn easier access to capital, many financing options, a variegate equity base, and a greater public image. Procedurally, the company hires an Investment Bank that acts as the underwriter for the company to make arrangements with the U.S. Securities and Exchange Commissions (SEC) and help the company appraise the value of its initial shares. However, it takes an entrepreneurially savvy business man to realize that the secret behind a successful IPO lies much less in the merit of the Investment Bank hired than the ability to create a positive information cascade. There exists a whole industry of investors that make their living evaluating and investing in private companies pre-IPO. The most lucrative IPOs are those that succeed in convincing several powerful investor that their company is worth the investment. The attention of these powerful investors garners the attention of other future investors. Soon enough, by virtue of a positive information cascade, investors start ignoring their own personal signals and simply push heaps of money toward “hot-commodity” IPOs.
The initial valuation of a stock of a company is critical to the success of an IPO. These initial valuations serve as the primary signals for the first investors. An overpriced initial valuation may turn off many preliminary investors, subsequently causing any future investors to ignore their own private signals and align themselves with the herd mentality, thus driving an IPO into a fiery heap of failure. Due to this potential information cascade of rejections, it is not uncommon to have IPOs with undervalued shares. A business man uneducated on the consequences of information cascades would be irritated that his company was valued under what it should be, but the savvy business man knows that the undervaluation of his stock sends a positive signal to investors, ultimately benefitting his company. These positive signals lure the initial investors to support the fledgling company, and thus induce an information cascade of acceptance causing future investors to also flock to the company. As you can see, the outcomes of initial share valuations is highly polar–ending either in loads of success of complete failure–and is one oft he reasons why Investment Banking and financial advising is highly valued in the financial industry.
The Information Cascade phenomenon not only applies to IPOs but also the whole financial industry. Everyday billions of securities are exchanged because of, for the most part, information gathered from others. The common man receives signals about a stock from perhaps a friend, the television, and the newspaper. By the time he makes his decision as to whether to purchase equity, he is already involved in a cascade of information initiated by someone else, whether he knows it or not.
Sources:
http://www.timothypollock.com/pdfs/amj08.pdf
http://nccur.lib.nccu.edu.tw/bitstream/140.119/4137/1/922416H004029.pdf