What is Underpricing?
Underpricing occurs in the finance world when a company prices its shares too low in an initial public offering.
How Does Underpricing Work?
When a company decides it wants to issue stock, bonds or other publicly traded securities, it hires an underwriter to manage what is a long and sometimes complicated process.
Determining the final offering price is one of the underwriter’s biggest responsibilities for two reasons. First, the price determines the size of the proceeds to the issuer. Second, it determines how easily the underwriter can sell the securities to buyers. Thus, the issuer and the underwriter work closely together to determine the price.
Once the underwriter is sure it will sell all of the shares in the offering, it closes the offering. Then it purchases all the shares from the company (if the offering is a guaranteed offering), and the issuer receives the proceeds minus the underwriting fees. The underwriters then sell the shares to the subscribers at the offering price. Although the underwriter influences the initial price of the securities, once the subscribers begin selling, the free-market forces of supply and demand dictate the price.
Underwriters work hard to determine the “right” price for an offering, but sometimes they “leave money on the table.” For example, if XYZ Company prices its 10-million share IPO at $15 per share but the shares trade at $30 two days after the IPO, this suggests that the underwriter probably underpriced the demand for the issue. As a result, XYZ Company received $150 million (less underwriting fees) when it could have possibly fetched $300 million.
Why Does Underpricing Matter?
IPOs are risky propositions for companies, because they involve sophisticated guessing about how much their shares are really worth to other people. Underwriters share in the risk of underpricing an offer, because they ultimately have to sell all the shares at the offer price. Underwriters often mitigate the risk of underpricing by forming a syndicate whose members share a portion of the shares in return for a portion of the fee.
Going public is a great way for many companies to raise capital. Though a bank loan might be an option, it requires monthly principal and interest payments that companies -- especially growing, cash-strapped ones -- may not consider wise uses of cash. Going public solves this problem in a way, because shareholders don't require monthly cash payments -- or any payments, for that matter, unless the company is sold.