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CHAPTER II THEORETICAL
FOUNDATION
Underprice or Initial Return is the different between the price at which the
firm’s stock was initially offered and the stock’s closing price on the first day of
trading (Ibbotson, 1975; Sidelar, & Ritter, 1988). Initial Public Offering (IPO) of
common stock is typically underpriced. This phenomenon has attracted analyst to do
a research regarding the factor that affect the Underpricing. It is reported by
Loughran & Ritter that underpricing at US market during 1980 – 1989 reach 7% and
during 1990 – 1998 hit 15% before reverting to 12% during the post buble period on
2001-2003. Comparing to Indonesia Stock Exchange (IDX) during 2001-2007 the
underpricing is 34%. For investor the underpricing is very attractive, but in other
hand the issuing firm can not get optimum fund from the IPO.
Initial public offering (IPOs) is the process when private company transposes
to be public company (where its shares are sold to other publicly). This process
usually called as “go public”. Going public provides a fresh source of capital that is
critical to the growth of the firm and provide the founder and others stakeholders such
as venture capitalist a liquid market for their shares. But this Initial Public Offer are
always risky to all parties : IPO issuer, investment banker and investors. It is very
difficult when investment banker & Issuer Company are valuing the price initially for
IPO since there is no observable market price before and there are no publish
information (operating & finance history) from the Issuer Company before. When the
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price is set too low the Issuer doesn’t get the optimum advantage from IPO to raise
the capital. But when the price is set too high, potential investor will get inferior
return from the investment, hence probably they will not interested to the offer.
Consequently, investor doesn’t want to buy the offering from this investment banker
with a record of overprice on offering. The accurate price (or close to accurate) of the
offering is required to provide advantage to both side.
This research will be focused to the relation between the Underpricing of IPO
of common stock at IDX and the Risk Factor & other disclosed information from IPO
prospectus. The notion is the higher the risk, the higher the return. Obviously it
requires empirical study to prove it. Some issuer reported so much Risk Factor;
meanwhile the others reported very small Risk. Prospectus is the first formal
information disclosure from the issuer company to public. It is expected to inform
potential investor regarding the company performance, hence the prospectus has to
include critical information that other has to know. We selected information disclose
in the prospectus to test its relation with the Underpricing phenomenon such as Risk
factor, Company Age, Auditor, Return on Investment and Financial leverage.
2.1. Capital Market, Initial Public Offer and Underpricing
Capital market is the place where long-term financial instrument were trade
such as long-term bond markets, equity markets and the derivative market for options
and future. A growing firm, Government and other institution usually use this capital
market to get Fund for its development. In other hand it become the tools for
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investment. Capital Market is bridging these needs between investor and the firm or
institution, as the place where equity can be traded.
In Indonesia Capital Market is regulated by “Undang-Undang Pasar Modal
No. 8 tahun 1995 tentang Pasar Modal”, and define the Capital Market as “kegiatan
yang bersangkutan dengan Penawaran Umum dan perdagangan Efek, Perusahaan
Publik yang berkaitan dengan Efek yang diterbitkannya, serta lembaga dan profesi
yang berkaitan dengan Efek”.
Generally Capital Market has important role for economic growth of the
country, it has two main functions:
1. First, as a place where companies or institutions to get Fund for development
or having competitive advantage from investor with minimum additional cost
of Fund. The gross proceed (the money obtained from the investor) is usually
used for expansion, working capital, or other financial leverage.
2. Second, Capital Market is tools for community, financial institution, Pension
Fund and government institution to invest in financial instrument such as
equity, obligation, mutual fund, bond, etc. So, investors can choose the
investment instrument with its risk and characteristic.
Indonesian Capital Market has been starting since Dutch colony set up Capital
Market in 1912 at Jakarta, it is followed in other city such as Semarang and Surabaya
in 1925. At this stock exchange the Dutch Colonial Government effects were traded
such as common stock, obligation, bond, etc. It was intended to finance Dutch
Colonial Company to expand and spread its wing to other colony. But, during world
War Two the activities was halted. In 1977, Indonesian government activates the
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stock exchange again by forming Badan Pelaksana Pasar Modal (BAPEPAM) which
was changed to Badan Pengawas Pasar Modal in 1991.
Common stock or equities represent ownership shares in a corporation. Each
share of equity entitles its owner to one vote on any matters in corporate governance
that are put to a share in the financial benefits of ownership. The IPO provides a fresh
source of capital that is critical to the growth of the firm and provide the founder and
others stakeholders such as venture capitalist a liquid market for their shares The
Company who want to sell it common stock at Capital Market is called “Go Public”
which means its share will be owned and traded publicly in Stock Exchange. In the
process to going public, the firm will issue initial offer to public, named Initial Public
Offer (IPO). The IPO issuer usually assigns investment banking (called underwriter)
to prepare the IPO. The investment banking gives an advice to the firm on which it
should attempts to sell the securities including preparing the prospectus, road show to
potential investor, setting up the price and register to Exchange committee
(BEPEPAM). Currently IDX is trading stock, obligation, preference share, right issue
and mutual fund. Among those products trading the stock is very attractive.
According to McConaughy, Dhatt, & Kim, 1995, Firms undertake an IPO for
two primary reasons. The first reason is as a mechanism for assisting the firms’ initial
shareholders in diversifying their holdings. The second rationale is to assist managers
(often the firms’ founder[s]) in procuring the necessary funding for undertaking new
projects. The IPO enables these individuals to sell a portion of their holdings in the
firm and utilize the funds generated from the sale of stock to diversify their
investment risk (Rock, 1986). Of these two reasons for undertaking an IPO,
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Arkebauer (1991) found that the need to generate funds to pursue new projects
dominated portfolio diversification. Basically IPO enables firm management to
pursue growth opportunities. Entrepreneurs routinely leverage themselves to a point
where they are unable to further increase either their own or the firm’s debt load.
Issuing firm via an IPO can be beneficial which are providing needed funds and
reducing the firm’s debt to Assets ratio. As found by Pagano, Panetta & Zingales,
1998, Rock, 1986 that even in those instances where additional commercial credit is
available to the entrepreneur, the covenants attached to the loan may be sufficiently
restrictive as to hinder his or her ability to pursue opportunities with high-growth
prospects, but also high risk.
Initial
public
offerings
(IPOs)
have
been
a
prominent
focus
of
conceptualization and empirical tests since the 1960s (e.g., Reilly & Hatfield, 1969).
It was studied by any parties particularly in the entrepreneurship. Attention to IPO
firm research is important for a variety of reasons. One of important reasons is that
research can help inform one of the more critical success factors in the development
of a firm. Undertaking an IPO moves the firm from the private to the public domain.
Few organizational transitions will receive the concentrated attention that an IPO
generates, as this generally represents the first time that firm-specific information will
be made available to the public. Usually any firm undertaking an IPO will provide a
series of documents that contain detail on the firm, the objective uses of the capital
generated from the IPO, and the company’s management. Potential investors will
carefully reviews these documents in an effort to assess the price/return prospects of
taking an equity position at the time of the IPO
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Initial Public Offer (IPO)
The process of offering a firm’s stock to the general public for the first time
according “Panduan Go Public” (Jakarta Stock Exchange) theoretically needs 195
days to proceed (see the chart attached), although it is quite complex and lengthy.
Upon deciding to undertake an IPO, firm management must first secure the services
of a lead underwriter (also commonly referred to as the investment banker). The
underwriters assist firms’ managers in preparing the extensive paperwork involved in
complying with regulation (Peraturan BAPEPAM No. IX.A.2), including the
registration statement, of which the prospectus is a part. is the prospectus is important
materials that serve as the primary marketing tool for the firm’s securities.
The IPO marketing process is started by what is called a “road show.” Road
shows involve the lead underwriters and key firm managers marketing the firm to
prospective investors (largely prominent institutional investors) via presentations in
major cities and one-on-one meetings with targeted investors such as mutual/hedge
fund managers. These presentations are focused on the firm’s operations, products
and services, and management. From the road show the firm/investment banker will
get feed back on demand for the firm’s stock and serves as a key input in the
investment banker’s final determination of the price at which the firm’s stock will
initially trade.
Upon completion of the road shows, and just prior to the actual first day of
trading (typically the day prior to opening day), firm managers and the underwriters
preparing the process to set the initial offering price. This is a critical decision point
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for firm management because once the price has been set, shares cannot be offered to
the investors at a higher price the first day of trading regardless of the level of
demand (Gordon & Jin, 1993). This process set initial stock price that forms the basis
for underpricing where there is difference in price between the initial stock price set
by IPO firm managers and the underwriters and the price of the stock at the close of
the first day of trading.
There are three main stages for company “going Public”, the first is preparing
its internal preparedness, the second is requesting permit to register to BAPEPAM,
the third is setting up Initial Public Offer (IPO). Before deciding to go public the firm
should consider the benefit and the consequences. According to “Panduan Go Public”
issued by Bursa Efek Jakarta, the benefits are :
a. Providing new sources of fund
Obtaining fund for company for development such as increasing working capital
or expansion usually become restriction for the company
9 Fresh Cash provided from selling the stock to public.
The company can generate a lot of cash and may accept simultaneously with
cheaper cost of fund compare to borrowing from the bank. Beside that
becomes a public company, the company can do secondary offering.
9 Flexible access to Financial Institutions
Becoming public company which its stocks are traded at IDX, will enhance
the company reputation particularly in banking sector. It was known because
the performance, the information is open publicly and bankers can decided
easily when dealing with the public company. Potentially the public company
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can issued new debt, competitive loan/interest, etc. Usually the credit given to
public company is lower then private company.
9 Better Access for public company to enter money market by issuing bond.
Usually the investor prefer to take public company
which have better
reputation.
b. Provide competitive advantage for firm development
c.
Perform merger and acquisition other company through issuing new share
d. Improving ability to “Going Concern”
e.
Better Company Image
f.
Increasing Company Value
Other benefit of Going Public :
g. Advantage in increasing capital in the future.
Going public company, will be preferable for investor since it has to open to
public all the financial performance, Management decision and other critical
information. The banker or other potential investor can assess the company prior
to invest in the public company. In other hand , if the private company want to
issue a bond or debt, baker/potential investor having difficulties to asses the
company performance and need extra work to investigate the company
performance since the information is asymmetric between the company and the
investor.
h. Improve liquidity of share holder.
The share holder can easily sell its share since the share price is known publicly
an dispute to set the selling price, meanwhile the private company doesn’t have a
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standard price hence, the selling price of the share need more work and evaluation
by potential investor.
i. Company capitalization is known
For company that want to give stock options incentive for its manager, need a fair
share price which is difficult for a private company.
Beside the benefit obtain from Going Public, there are also some disadvantage to
become public company, such as :
a. Increase report expenses
Since the public company has to inform the shareholder regularly the financial
statement and any corporate action, it increase the expenses of the report
issues which is sometimes quite expensive..
b. Disclosure
Some company actually doesn’t want to open all information or expose it
business plan, since it will use by the competitors to improve or follow the
business strategy.
c. Take over issue
Company management have limited veto in public company. Manager will be
easily replaced by the new owner when the majority shareholder was changed.
For firms undertaking an IPO, usually the price at the first day of stocks trading is
higher than the firm’s stock was initially offered, this phenomenon is named
Underpricing (Ibbotson, 1975; Ibbotson, Sindelar, & Ritter, 1988; Ritter, 1998).
Underpricing phenomenon is a common occurrence and very attractive to financial
analyst. In the review of the empirical evidence on the initial return of common stock
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offering, Smith concluded that the return from offer price to after-market price have
exceeded 15%. It simply that underwriter consistently offers the securities at
substantial discounts from their values that are set in the after market. In other words,
initial public offerings (IPO) appear to be underpriced.
Underpricing
As mentioned before that Underpricing is the difference between the price at
which the firm’s stock was initially offered and the stock’s closing price on the first
day of trading. It is a worldwide phenomenon of almost all capital market that the
issue price of initial public offerings is below the first trading price on the secondary
market. Numerous empirical studies find evidence that the first trading price is about
20 per cent higher than the issue price of the shares on average. For some capital
markets this difference comes even up to 55 p.c. and more. For the investor,
underprice return significant benefit in the short-term trading. In other hand for
issuing firm, the underpricing reduce the money that should be gotten from the IPO or
“leaving money on the table”. This is a good business for the investors who
subscribed to the issue and received an allocation because they are enabled to realize
considerable trading gains in a few days only. On the other hand, there is a
considerably lower amount of money which flows into the enterprise (or the
remaining shareholder) if the issue price is below the trading price on the secondary
markets. Thus, many investments could not be realized.
The fact that IPO company rarely complain about leaving the money on the
table and it become a puzzle to financial economists. Brealy and Myers (1996) state
after discussing an IPO that tripled in value on its first day of trading, “contentment at
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selling an article for one-third of its subsequent value is a rare quality”. During 19901998 companies going public in United States left more than $27Billion on the table,
due to underpricing (Tim Loughran & Jay Ritter, 2002). Underpricing averages just
over 16 percent historically (Ibbotson, Sindelar, & Ritter, 1988; see also Krinsky &
Rotenberg, 1989; Loughran & Ritter, 2001). During the Internet bubble of 1999 and
2000, however, underpricing was higher at an average of 65 percent (Loughran &
Ritter, 2001).
In IPO process, the issuer want to get as much as possible the gross proceed
from IPO. If the offer price is so high, the issuer will get more money. But investor
may et small return from the investment at the share, hence the investor only want to
buy the offer price with significant discount. For underwriter, the higher the gross
proceed the bigger fee can be obtained. But if the offer price is too high and no much
investor want to buy, then the underwriter has to buy the share. The underwriter will
be loss and jeopardize its reputation, this is one reason why the IPO frequently
underprice. Seha M. Tinic (1988) explained the underpricing theory with the follow
reason :
a. Risk-Averse-Underwriter Hypothesis
Investment bankers purposely underprice new common stocks to reduce their
risks and costs of underwriting (the underwriter risk avertions). The underwriter
want to reduce the chances of ending up with an unsuccessful issue and the
associated losses. Although it may have some superficial appeal, this explanation
is not very satisfactory. It fails to address why issuers do not insist on investment
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bankers to adjust their underwriting spreads to compensate for the risks of the
offering.
b. Monopsony-Power Hypothesis
The investment banker has monopsony power (single buyer) in underwriting
common stocks of small firm and it may cause underpricing (Ritter). Their
conclusions were based on the observation that large, reputable investment
banking firms generally do not accept to underwrite common stocks of small,
speculative, start-up firms. Those firms have small acceptance in investment and
very high risk. The investment banker particularly for full commitment
underwriter has to buy the common stock, since it has liability to sell all stocks.
Hence the investment banker tent to underprice those common stock. Ritter
stated, "Major bracket underwriters generally refuse to underwrite small offerings
from start-up firms, possibly for reputation reasons." According to Ritter, the IPO
market is segmented. The IPOs of small firms are underwritten by investment
bankers who, for some unexplained reason, can exercise greater bargaining power
over the issuers. These investment bankers intentionally underprice the common
stocks, to avoid unsold the stocks and merely maintain their reputation.
c. Speculative-Bubble Hypothesis
Speculative investor who could not get allocations of the oversubscribed IPO
share from underwriters at offering price will buy the share from the market with
higher price, expecting to get capital gain from the secondary market. Although
the offering prices of the IPO firms were consistent with their underlying
economic values. Unfortunately, the speculative investor pushed their prices
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much higher than the offering price. The speculative-bubble hypothesis would
imply that the initial positive excess returns of the IPOs should be followed by
negative excess returns as the bubble bursts sometime later.
d. Symmetric -Information Hypotheses
This hypotheses according to Baron model assumes that the investment bankers
have more information about investors demand for the securities than the issuers
possess and the investor. The investment bankers reputations may help in
certifying the quality of the issues and generate demand. The underwriter who has
better information of capital market set the offering price since the issuer is
uncertain about the market and the equilibrium price of its stock. The issuer has to
compensate the investment banker for the use of this superior information by
letting him or her offer the securities at a discount from the price expected in the
after market. This condition set underprice phenomenon to the IPO firms.
In this research
we will focus in evaluating the underpricing due to information
asymmetry, particularly the Risk factor heading by the issuer and other disclose
information that are opened in the prospectus. As we know the prospectus is expected
become one tools to share information between the issuer – the underwriter and the
potential investor. The prospectus may eliminate the gap in information asymmetry.
Normally the company that doesn’t have track record publicly, will be considered
riskier by investor. Hence the uniform investor will value underprice on the company.
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2.2. Prospectus and Risk Factor
Undertaking an IPO moves the firm from the private to the public domain.
Consistent with “BAPEPAM IX.C.2” regarding “Pedoman Mengenai Bentuk dan Isi
Prospektus dalam Rangka Penwaran Umum”, and “Lampiran Keputusan Ketua
Bapepam Nomor Kep-51/PM/1996 tanggal 17 Januari 1996”, Any firm undertaking
an IPO must provide a series of documents that contain detail on the firm, the
intended uses of the capital generated from the IPO, and the firm’s managers. The
disclosure of this information are set in IPO prospectus and presentation arrange by
underwriter during the road show. Potential investors will carefully scrutinize these
documents in an effort to assess the price/return prospects of taking an equity position
at the time of the IPO, this will minimize asymmetry information of the potential
investor.
The investment banker and the issuing firm reports those information needed
by investor in Prospectus. There are four critical item has to be included in the
prospectus :
9 Prospectus Summary
9 Risk Factor
9 Use of Proceeds
9 Management Discussion and Analysis (MD & A)
The underwriter who prepare the prospectus has to include relevant risk
factors (such as: new product, few or limited products, inexperienced management,
technical risk, seasonality, customer dependence, supplier dependence, competition,
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legal proceedings pending against company, government regulation) pertaining to the
company. The purpose in requiring the firm to detail the relevant risk factors is to
provide potential investors the opportunity to fairly assess the uncertainty facing the
IPO firm. Firms with greater numbers of risk factors are associated with higher
uncertainty (e.g., Beatty & Zajac, 1994; Welbourne & Cyr, 1999). The increase in
uncertainty is likely to be associated with higher levels of underpricing. Hence the
risk factor has to be detailed particularly to risks that relate to company specific
operation. Also by disclosing all the risk factors of the issuer, it will avoid future legal
liability by the investor if there is information that is not disclosed and affect the
issuer performance.
Risk Factors
Risk factor disclosure is important beside as obligation for IPO company, it
also because corporate transparency about risk is vital for the well-functioning of
capital markets. To achieve and maintain an accurate valuation of a company’s stock,
confident and well-informed investors are necessary. Issuer firm managers have
superior information compare to outside investors, who may not fully understand the
underlying risks and rewards of a firms’ business (Hutton 2004), meanwhile the
underwriter has better understanding regarding the capital market & potential investor
compare to the issuer firm managers. By providing investors with information about
the risk associated with carrying out the company’s strategic goals, managers can
increase transparency and eliminate disparities between what investors understand
and expect and what management can deliver. By having more accurate information
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for the risk, the investor can value their investment properly, and preventing stock
prices to become unpredictable. According to Fuller and Jensen (2002) “trying to
mask the uncertainty that is inherent in every business is like pushing on a balloon;
smoothing out today’s bumps means they will only pop up somewhere else
tomorrow, often with catastrophic results”. Consequently, being clear about the risks
and uncertainties involved can prevent severe damage to long-term health of a
company that may otherwise result from overvalued corporate equity (Fuller and
Jensen 2002).
Unfortunately, although managers of issuer recognize the potential benefits of
risk disclosure to investors and long-run health of a company, it is still questionable
whether managers are forthright about the underlying risks in their firms’ business.
On the one hand, they may understand the benefits of risk disclosure and realize that
markets will penalize companies that provide inadequate information relative to their
peers. Probably one managers perceive that risk disclosure is a competitive advantage
in attracting capital and managers may fear litigation and reputation costs if they do
not provide sufficient risk information to investors (Skinner 1994 and 1997). Also
hiding risk can cause the stock price to fall to a more sustainable level in the shortrun. Additionally, disclosure is not a costless undertaking (Botosan 1999). First,
creating and distributing timely and accurate risk information consumes valuable
management time. Second, managers may perceive there is a cost imposed on the
firm by competitors who exploit the information to the detriment of the disclosing
firm. Third, there is the possibility of litigation in connection with a disclosure.
Finally, companies may be afraid to set a disclosure precedent they can not stick to
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(Hutton 2004). Beside those reason, disclose the risk factor may be seen by issuer
competitor as weak point and may be used to win the competitor.
Another potential problem also occur when trying to regulate risk factor
disclosure is that much of the risk information is industry and company specific, and
that the most relevant information changes constantly, as a result of rapid economic
and technological changes. As stated by Hutton (2004): “relevant information does
not lend itself to standardization”. Mostly issuer firms write in a large degree of
discretion in drafting risk sections. Actually the narratives must explain in simple
language how certain risk factors affect the company, but should exclude risk factors
that could apply to any company. It is up to the underwriter to decide which risk
factors are significant and should therefore be discussed. Consequently, some have
argued that risk sections do not contain reliable information, because the rules are
“subjective, open-ended and ambiguous, which allows firms to report almost
anything (or nothing) without violating the requirements” (Schrand and Elliot 1998).
According to Beatty and Welch (1996), issuers, underwriters and experts can indeed
mitigate their exposure to legal liability by disclosing more risk factors in the
prospectus. However, by shifting risk to investors, the marketability of an issue is
reduced and the issue price should be lowered (Beatty and Welch 1996). The latter
mechanism may prevent disclosure of redundant risk factors.
According BAPEPAM regulation, basically the prospectus has to content
minimum firm risk. Each company has specific Risk factors. Hence disclosing the
Risk Factor has to be as detail as possible, so the investor is provided important
information to decide the investment plan. The Firm Risk has to include :
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a)
Competitor
b)
Resources/ material supplies
c)
Regulation in the country or at foreign country and other permits
related to firm operation
d)
Government policy
Risk factors included in the prospectus are expected to be specific to each firm
and to reveal important information. As a rationale risk-averse investor, it is expected
that the higher the risk, the higher the return. The gain by risk-averse investors is
proxied by the underpricing. We expect that the effect of the risk factors will be
positive and significant on the underpricing and traders are selective in their valuation
of the risk factors. Such factor will be weighted highly and significant compare to
others risk, for example, always professionals are concerned with the risk of limited
experience of a potential director The risk factors are divided into several categories.
Each category consists of related risk factors cited in the prospectuses of our sample.
The categories are :
1- Management Issues:
Anti-takeover provisions: refers to the provisions in a company’s by-laws that may
pose difficulties for an acquisition. Such by-laws have negative effects on possible
acquisition attempts.
Control by directors: The majority of the power is held by the directors, management
and executive officers. And, companies with high level of control by directors will
have the same ownership structure after the IPO as well.
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Control by existing shareholders: The majority of the power is held by existing
shareholders and these companies will have the same ownership structure after the
IPO.
Control by principal shareholders: The majority of the power is held by a principal
shareholder or by a very small group of shareholders. As well, the same ownership
structure will be in effect after the IPO as well.
Dependence on key personnel: The company's operations, finances and/or
management may be dependent on a specific key employees who are hard to replace
and also expensive to retain. This risk factor is more for the high tech companies
where human resources are limited.
Limited experience: The management or staff may not have extensive experience in
the field of operations. It is also common to have limited experience for the areas
towards which the company extends its operations.
Human resources & labor issues: The scarcity of qualified employees is seen as a
problem especially in narrow very specialized fields of operations. Most of the high
tech companies hire international employees to fulfill their qualified employee
shortage. The labor issues recently become main problem in some company that need
massive labor in production line. Particularly with current reform era, many labor
union do strike to urge company fulfill they want. Absolutely it will creat uncertainty
to the company.
Limited director liability: This refers to the liability of the managing directors’
liability towards the company, its operations and its products are limited. While the
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company has full liability and this liability is transferred to shareholder's investments,
the limited director liability is seen as a risk factor.
2- International Trade Issues:
Foreign imports: Retail companies face foreign companies competing in the
domestic market and/or competing for a foreign market. High tech companies on the
other hand face foreign competition risk in terms of foreign sales.
Import transactions: Due to distant locations between domestic companies and
foreign companies, domestic companies may face the risk of delayed import
transactions. In addition to the risk of costly operational interruption, they also may
cause companies to lose reputation.
Currency & International trade restrictions: This risk factor includes import
restrictions and exchange rate fluctuations. In such, companies with imported
material dependency that faces the risk of import restrictions. Such risks pose risks on
the flow of operations and sometimes may be vital for its survival. In addition, for
high-tech companies import restrictions are referring to restrictions on employing
foreign nationals. This implies restrictions on visas and related issues (this is
pronounced for software companies). Exchange rate fluctuations refer to a company
that is exposed to any changes in foreign exchange rates. This is mostly the case for
retail companies that are dependent on imports and/or have high level of foreign
sales. High tech companies with dependency on foreign contracts are also exposed to
this sort of risk factor.
3- Technological Issues:
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Intellectual property and intangible assets: A risk factor that is pronounced in the
sample of high-tech companies is the dependence on intangible assets and intellectual
property. This includes the dependence on the ownership of copyrights, goodwill,
trademarks and patents. The loss of these intangible assets due to external factors
such as technological changes poses a risk.
Rapid technological changes: Rapid technological changes especially for high-tech
companies are big threat. These changes may stimulate companies to grow and hence
may expose to new risks. Also, these changes may force companies to file for
bankruptcy if they could not cope to such changes.
4- Operational Issues:
Quarterly fluctuations: This refers to the risk that a company's operations are
affected by quarterly fluctuations.
Managing growth: Growing companies require additional resources such as new
staff, operational know-how and financial aspects.
Product liability: Some companies may have product liability as a result of mistakes
in products or conducting business. Litigation cases can be very costly.
Operating System: This risk is defined as how the company set up the system to
achieve the production. Some company reported that failure in equipment or tool in
production line will impact significantly to the company performance. The production
target is very tight and has to be achieved to support company income.
Seasonality, Regional Limitations and Incident: Seasonality is defined as the
company's operating results follow a seasonal pattern. Although this seasonality may
be similar to quarterly pattern, the seasonality is more explained in terms of seasonal
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changes rather than strict quarterly pattern. Regional limitations happen when a
company has regional existence and regional distribution channels. Retail companies
are the ones that are exposed to regional limitations risk due to their dependency on
regional resources. Including in this category is also Incident which related to
situation that impact to company productivity such as fire, structure failure, etc.
Uncertain market and government contract: Uncertain market refers to companies
with new products are facing the risk of uncertain market for their products or
services. Government contract refers to contracts between companies and the
government. Companies are exposed to risks if the contract is not renewed or if it
includes high liability clauses. Larger discounts involved with government contracts
are also seen as a risk.
5- Financial Issues:
Debt service requirements and restrictive covenants: Debt service requirements refer
to the risk of any existing debt that the company has before the IPO that needs to be
either renewed or refinanced after the IPO. Restrictive covenants refer to any loan
agreement that may have restrictions on the company. These restrictions may be
operational, financial and/or managerial.
Dilution: Dilution refers to the probability of extensive fluctuation of the stock price
after the IPO, and the price may be diluted for the IPO. In other words, the price may
depreciate immediately after the IPO. This can be seen as a risk of exposure to
volatility.
Liquidity : Some companies are very dependent to financial liquidity, such as
insurance company, finance company, to sustain its operation. When the insurance
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company can not cover the claim from the client, it will impact to company
performance also.
Discretion over use of funds: This refers to how the proceeds from an IPO will be
used in the sense that the decision is based on the managing directors’ wish. They can
be used to pay existing debt or to pay debt servicing.
High level of debt: Companies with high leverage ratios are exposed to more
financial risks than others. The cost of debt and ability to finance it are also included
into the risk.
Historical and recent losses: Historical losses refer to those companies with
systematic historical losses. Companies show concerns that such patterns may
continue and there is a high probability that they may have losses in the future as
well. Recent losses refer to a company that realized losses only recently. Although
these losses are not historical and they are not part of a historic pattern, the
companies’ future operations may be affected with their recent losses. These recent
losses may also indicate that the company is not profitable and may not realize any
profits in the future.
Need for additional financing: A company may need additional financing for growth
or to finance historical/recent losses. The ability to provide the needed funds is seen
as a risk factor.
No dividends: Companies that have never paid dividends and they have no intention
of paying any may lose some investors.
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No prior market: Companies that go for an IPO has no history of any technical
analysis about their stock. Therefore, any reference to historic value is not possible.
Working capital deficit: Companies' may require more working capital for expanding
operations and/or for financing debt. Ability to finance such need is exposed to
companies as a risk factor.
6- Market, Economic and regulatory Issues:
Competition: refers to the level of competition which is given as a risk for the
companies that exist within competitive markets.
General economic conditions: This refers to the cyclicality of the macro economic
conditions. Although all companies will be affected by such factor, different
companies will not be affected in the same way (either in direction and magnitude).
Government permit & regulation: Any sort of government regulation that may affect
operations, sales and/or financing would have an effect on the companies. Tax
regulations are one of the main concerns.
Socio and politic situation : this risk very specific to developing country where the
political condition is unrest. Particularly to company expose to public issue such as
land acquisition, rebellion or terrorism, ect.
2.3. Control Variable (Others Factor affect Underpricing)
Beside the risk factors that has to be exposed to investor prior to IPO, the
investor will also look for other information that are influencing the Valuation of the
IPO. There are several item that probably affect the IPO such as : Auditor Reputation,
Firm age, Company size (represented by Gross Proceed), Profitability, Financial
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leverage And many other. In this research with include some items as control variable
to evaluate the risk factors.
2.3.1
Auditor Reputation
Company with favorable inside information to present to investors will hire
high-quality auditors (Titman & Trueman, 1986). The reputable auditor will become
a powerful signal to potential investors, since high-quality auditors will be less
subject to pressures from firm management and more discriminating in their audits
(Feltham, Hughes, & Simunic, 1991). The auditor clearly understand that failure to
disclose negative information in IPO may bring the auditor to shareholder to a
lawsuits. The reputable auditor has capacity to audit in detail the company
performance and doesn’t want to jeopardize its reputations. As a result of these
reputational and legal constraints, entrepreneurs who believe that unfavorable
information about the firm and its prospects will negatively impact investors’
perceptions are unlikely to hire high-quality auditors. High-quality auditors, often as a
function of their experience with prior IPOs, may be more likely to uncover negative
information.
Originally there are five high quality auditor, since “Enron” case, the Big Five
auditor company became the Big Four only. They are :
1. PricewaterhouseCoopers, affiliated with KAP Drs. Hadi Sutanto & Rekan,
Haryanto Sahari & Rekan.
2. KPMG (Klynveld Peat Marwick Goerdeler), affiliated with KAP SidhartaSidharta & Widjaja.
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3. Ernst & Young, affiliated with KAP Prasetio, Drs. Sarwoko & Sanjaja.
4. Deloitte Touche Thomatsu, affiliated with KAP Hans Tuanakota & Mustofa.
When auditor reputation is not maintain properly, then probably they will not get the
job to audit in the next years, hence the auditor will keep th equality of its result.
Research fromh Wooten (1981) show that the Big four auditor tent to present better
performance compare to small audit company (non the Big Four), it is mainly
because they maintain its reputations. Also Big Four auditor usually has better
resources (competent people, expertise, sophisticated system and proper procedure.
Hence in investor see the Big Four auditor as a guarantee that the company has good
financial management. In relation with the underpricing, the IPO company who does
not hire the Big Four Auditor will have more uncertainty and less acceptance by the
investor. Hence the investor will ask bigger discount price to the company that hire
non Big Four Auditor. The majority of studies investigating the association between
auditor reputation and underpricing have documented a negative relationship (e.g.,
Beatty, 1989; Feltham, Hughes, & Simunic, 1991; Michaely & Shaw, 1995).
Consistent with these findings, and consistent with the premise that high-quality
auditors will reduce uncertainty surrounding the IPO. In this research we expect that
the IPO company with non Big Four Auditor will return bigger underprice.
2.3.2
Firm Age
Young company who don’t have proven track record expose to uncertainty.
As Carter, Dark, & Singh, 1998; Ritter, 1984, 1991, state that the age of the firm has
served as a surrogate for risk in previous IPO research, i.e., more established firms
are less risky. Young firms will have fewer years of published financial data and are
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less likely to have been assessed by financial analysts. Well establish company have
long time experience in operation and had published its performance. Investor prefer
to spend the money at experienced firm and if the investor want to invest at young
company they will undeprice it. Consistent with the decreased level of uncertainty
the offer price tent to be underprice. We expect the company age has positive
correlation with the underprice.
2.3.3
Company Size (Gross Proceed)
Company size is also at issue. Larger firms, as compared to smaller firms,
present less uncertainty for potential investors. Larger organizations, for example,
have greater access to resources essential for firm survival and profitability (Finkle,
1998). Also, several studies have found a negative association between firm size and
underpricing (e.g., Carter, Dark, & Singh, 1998; Ibbotson, Sindelar, & Ritter, 1988;
Ibbotson, Sindelar, & Ritter, 1994; Megginson & Weiss, 1991).The company size is
generally represented by the gross proceed (a function of the total number of shares
offered with the IPO and the offering price of those shares). Another hypotheses a
correlation between firm size and IPO firm performance is that larger firms tend to
attract more prestigious underwriters and potential investor. It is very common that
the small company may be perceived offering lower performance potential, therefore
the underwriter will avoid to bear any loss due to undersubscribed issue. Underwriters
will also be concerned about passing on a riskier issue to their clients, thereby
jeopardizing future client business. The company size is expected to have negative
correlation with the underpricing. In this research the company size is represented by
gross proceed which is also named as amount filed by the IPO. Larger IPOs, in terms
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of the number of shares and the offering price, would normally be offered by big and
more established firms, which should reduce the perceived risk of the offering (for
discussions, e.g., Carter, Dark, & Singh, 1998; Dunbar, 2000; Jain & Kini, 2000). the
smaller offerings are usually more speculative and has greater uncertainty than their
larger company. Accordingly, we expect that that IPO gross proceed will be
negatively associated with underpricing.
2.3.4
Profitability or Return on Asset Ratio (RoA)
The profitability is the indicator how the company operation return profit that
show the effectiveness of the company. The potential investor expect more gain
obtained when they invest in the IPO company. Hence the bigger the profitability the
higher the profit of the IPO company and later on the investor will get more money
from their investment in the company. Generally the investor prefer to invest in the
company with higher profitability. In the opposite if the IPO company has lower
profitability, the investor want bigger discount in the IPO price or lower price of the
IPO company. According to Daljono (2000), higher profitably will reduce uncertainty
of the company prospect hence it will reduce the underpricing level.
Mathematically profitability can be formulized as follow :
Profitability (RoA) =
2.3.5
Net Profit
Total Assets
Financial leverage or Debt to Asset Ratio
Financial leverage or Debt to Asset Ratio (DAR) is the indicator of company
healthiness. The company with higher DAR (having bigger debt) finance its operation
using debt, meanwhile the company with lower DAR, is self financing its capital and
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operation. Hence the higher debt to assets ratio the riskier the company will be facing.
The investor theoretically prefer the company with lower DAR, otherwise investor
want to buy the equity with bigger discount price if the issuer have high financial
leverage. Janice C.Y. How (2002) mentioned that financial leverage variable correlate
with the underpricing, meanwhile Ghozali and Mansur (2002) research found that
financial leverage and underwriter reputation has negatively significant correlation
with underpricing. In this research we use this indicator as control variable and
expects the higher the financial leverage the higher the underpricing of the IPO firm,
in other word we expects the financial leverage has positive correlation with the
underpricing. The financial leverage can be formulized as follow :
Debt to Asset Ratio (DAR)
= Total Debt
Total Assets