When a company is launched on the stock market, it may be expected that the original owners would want to receive as high a price as possible for their initial public offering (IPO). In fact, according to Michael Brennan and Julian Franks, there are strong incentives for ‘insiders’, the company’s directors, to underprice the issue as a means of retaining control.

An IPO is said to be underpriced if the price at which the security trades in initial dealings exceeds the offer price at which it was sold to investors. Brennan and Franks argue that pre-IPO shareholders, who derive private benefits of control, underprice the issue so as to ensure oversubscription and rationing. Rationing allows the owners to discriminate in the share allocation process so as to limit the size of the largest shareholdings. This reduces the probability that they will be subject to the monitoring of a larger shareholder or to a hostile takeover.

This ‘control’ theory suggests several testable propositions. First, that underpricing and the consequent oversubscription is used to discriminate in the rationing process against large applicants and in favour of small ones.

Second, that using the rationing process to create a more diffuse post-IPO shareholding makes it more costly to assemble large blocks of shares. If such rationing is used, it may be expected that smaller blocks emerge subsequent to IPOs with greater underpricing.

Third, that if directors obtain private benefits from control and also set the issue price, it may be expected that the lower the fraction of underpricing costs borne by directors, the greater the underpricing.

Testing these hypotheses is assisted by the formality of the UK new issue process in which, in the vast majority of cases, potential purchasers must submit quantity demands at a fixed price specified by the issuer. In the event that the issue is oversubscribed, the available shares, and therefore the gains from underpricing, must be allocated by a formal rationing scheme.

Brennan and Franks use data from a sample of 69 IPOs made in the UK over the period 1986–9, 64 of which were fixed price offerings. They find that holdings by directors were reduced by about one-third: from 42% of the pre-issue number of shares outstanding prior to the IPO to 29% seven years later.

In contrast, holdings by other (private) shareholders were virtually eliminated over the same period, declining from almost 42% of the pre-issue number of shares to less than 3%. Holdings by other (institutional) investors fell almost as dramatically. This suggests that non-directors see the IPO as a vehicle for disposing of their shares, and although their ownership at the post-IPO stage remains substantial, it is only temporary.

Private companies and large public corporations represent opposite extremes of the relationship between ownership and control. The IPO is a key step in the evolution of a management-owned firm into the public corporation, and in the separation of ownership and control. These results indicate that in less than seven years, almost two-thirds of the offering company’s shares have been sold to outside shareholders, thereby substantially advancing the separation process.

The researchers detect substantial rationing in many of the new issues in their sample. The rationing frequently discriminates against the large investor and in favour of the small investor, and this discrimination appears to be positively related to the degree of underpricing.

They next turn to the results of the control hypothesis. The first and second hypotheses propose that the greater the underpricing, the easier it is for firms to introduce rationing in the share allocation process, and therefore to render it more difficult to assemble large blocks after the IPO.

The control hypotheses predict that the larger the underpricing, the more diffuse the shareholding structure and the smaller the size of post-IPO blocks. When the dependent variable in the analysis is the largest outside holding or the total of large outside holdings, there is strong evidence that underpricing does tend to prevent the formation of large blocks of shares in the hands of outside shareholders.

The costs of underpricing are borne by the pre-IPO shareholders but may be borne differentially by different investor groups. This distinction is important because directors may derive greater private benefits of control and may have more influence in setting the issue price than other shareholders. If the shares sold in the IPO all come from non-directors, directors may be more inclined to underprice.

Hence, the third hypothesis proposes that the lower the fraction of underpricing costs borne by directors, the greater the underpricing. An important assumption is that directors and not other insiders set the issue price and therefore determine the extent of underpricing.

In their analysis, underpricing is used to calculate the costs borne by directors, so Brennan and Franks use the rate of oversubscription as the dependent variable since the higher the level of underpricing, the greater the level of oversubscription. The results show that the fraction of costs borne by directors is not a significant variable in explaining underpricing, although the coefficient has the right sign.