Live 8 Tickets, IPOs, and Dutch Auctions (oh my!)

Q: What do Live 8 tickets and IPOs (Initial Public Offerings) have in common?

A: They're both underpriced and sell in the aftermarket for a higher price than they did initially.

The IPO underpricing phenomenon has around for many years. For the layman, here's what "underpricing" means in the context of an IPO (or a ticket sale): A company goes public, and shares are offered to the public at, say $20. The shares often (not always, but frequently enough) trade much higher by the end of the next few days. In the case of Google, the stock was initially offered at an initial price of $85. The stock's price closed trading at the end to the initial day at $100 (it had actually been much higher during the day, but that was the closing price). Since Google issued 15 million shares, that's an additional $210 million dollars that Google could have received in the offering, but didn't.

Is this bad? From a strictly financial standpoint, underpricing merely means that the issuing firm (or concert promoter) left money on the table. Subsequent trading allows the market to revalue the shares to what it thinks they should be, rather than the price set by the issuer.

One reason that underpricing occurs is that there's an agency problem. The underwriter (or promoter) sometimes makes a "firm commitment" on the IPO, where they take on the risk that the issue won't sell out. So, if there are unsold shares (or tickets), they have to buy them from the company. Since this exposes them to a significant amount of risk if the issue doesn't sell out, they rationally price the shares/tickets "to sell" (i.e. at a discount from what they perceive as fair value. In fact, there's some evidence that "firm commitment" IPOs are more underpriced than those sold under a "best efforts" contract.

Another reason for underpricing is more benign - the underwriter (or concert promoter) merely guesses wrong. One way to correct for this is to use alternate methods of setting the price of the offering. For example, some firms going public set their initial offering price via a "dutch auction", prospective buyers send in sealed bids where they reveal how much they'd be willing to pay for how many shares. Here's an example of how this could work for a concert (or a stock issue):

Assume that there were 5 tickets for sale (it's a small concert). Here's what potential buyers say they'd be willing to pay:

• Jim states that he'd be willing to pay $15 for a ticket.
  
• Charlie would be willing to pay $20 each for two tickets
• Amy would be willing to pay $30 each for two tickets
• Bill would be willing to pay $40 each for two tickets
• Jacque would be willing to pay $50 for a ticket
• Melissa would be willing to pay $55 for a ticket
• John would be willing to pay $60 for a ticket
  

In a dutch auction, you'd start at the highest price and go down the list until you've sold out the allotment. At the $40 price, the market would "clear" (i.e. all tickets would be sold). The tickets would therefore be sold at $40 each, netting the promoter $200.

The alternate would be for the promoter to guess what price would clear the market. What would happen if the price were set at $15? Some sort of mechanism other than price would have to determine how the tickets were allocated, like "first come, first served, or bribing the investment banker (er, promoter). If so, the individuals who value the tickets more than $15 would buy them from the initial holders in the aftermarket (like on Ebay, which conducted their own recent IPO using a dutch auction).

Hat tip to Catallarchy for the link.