Alternatively, issuing companies may intentionally underprice
their shares in order to generate excess demand and attract a large number of small shareholders.
Welch (1989) theorizes that high-quality firms may underprice IPO shares more severely to signal their quality to the market and then raise capital on more favorable terms in subsequent seasoned equity offerings.
If focused firms underprice more to signal quality, then according to Welch (1989) they may be more likely than diversified firms to return to the equity market for a seasoned offering.
An alternative explanation for the underpricing difference that we observe suggests that focused firms may be higher quality firms and that they underprice their IPOs more severely, recovering that cost in subsequent seasoned offerings.
In this framework, it is possible that some managers will underprice to generate dispersion, not for the purpose of avoiding a transfer of control but rather to maximize the proceeds from ultimately relinquishing control.
Brennan and Franks (1997) and other papers suggest that entrepreneurs faced with a control threat can underprice more at the margin in an attempt to reduce the post-IPO concentration of share ownership and, as such, the likelihood of an unwanted turnover in control.
The argument that insiders strategically underprice as a function of M&A activity in order to influence the firm's post-IPO ownership structure may seem at odds with the conventional wisdom concerning the interactions among issuers, underwriters, and investors.
Underwriters have an incentive to underprice IPOs if they receive commission business in return for leaving money on the table.
Allocating these hot IPOs to the decision-makers of issuing companies and their friends (through friends and family accounts) allowed underwriters to underprice even more.
Specifically, just as firms with favorable private information underprice to increase the proceeds from subsequent seasoned offerings, insiders may also recoup the costs of underpricing through subsequent open market sales of their shares at a more favorable price.
If initial (pre-IPO) shareholders (owners) underprice to signal their quality and thus obtain a more favorable price on subsequent sales of equity, they may also recoup their losses due to underpricing by selling their shares in the open market.
Under the null hypothesis of Welch's |31~ signalling theory, firms that underprice more are more likely to reissue equity in the future.