Employee Stock Options and the Underpricing of Initial Public Offerings

The central question surrounding the IPO underpricing puzzle is why issuers are willing to sell their shares at a price that is less than what the market is willing to pay. This paper shows that a major reason why managers are willing to underprice shares at IPO is that they use options and stock grants to protect themselves from the dilution to their existing shares. Underpricing can have a large positive tax effect for options they hold in addition to making new options more valuable. I show that underpricing shares can increase the tax advantage of paying employees with options. Managers can also use underpriced shares as currency to strengthen strategic alliances and customer loyalty. A major finding of this paper is that the use of options is directly related to IPO underpricing and explains a substantial amount of the variation in firm underpricing. It is unlikely that this benefit is driving IPO underpricing. Firms backed by venture capital have greater underpricing and also employ more options. CEOs who are not firm founders benefit more from the tax benefit, on average, than they lose in dilution, while founder CEOs are less likely to come out ahead. * The Wharton School, University of Pennsylvania. Phone: (215) 898-7617. E-mail: [email protected] I am grateful to Paul Asquith, Espen Eckbo, Diego Garcia, Pete Kyle, Rich Lyons, Stewart Myers, Gordon Phillips and David Sharfstein for their comments. Comments and suggestions will be greatly appreciated and can be sent to [email protected]