Critical analysis of a potential Formula 1 IPO

Bachelor Thesis 2014 100 Pages

Economics - Finance


Table of contents

Index of Abbreviations

Table of figures

Index of Appendices

1. Introduction
1.1 Background and motivation
1.2 Research question
1.3 Procedure

2. Theoretical framework
2.1 General framework
2.1.1 Definition of IPO
2.1.2 Involved parties
2.1.3 Main elements and key steps of the IPO process
2.2 Fundamentals of IPO price determination
2.2.1 Company valuation IPO
2.2.2 IPO pricing Process of price determination Underpricing
2.3 Stock exchange and exchange segments
2.4 Advantages and disadvantages of a public listing, from the issuer’s perspective

3. Formula 1
3.1 History
3.2 Ownership and company structure
3.3 Economic standing of the Formula 1
3.4 Future opportunities and threats

4. Going public of the Formula 1
4.1 Motives and incitements for going public
4.1.1 Issuer’s perspective
4.1.2 Investor’s perspective
4.2 Technical details of the IPO
4.2.1 Choice of the stock exchange
4.2.2 Share structure
4.2.3 Market environment
4.2.4 Requirements
4.2.5 Formula 1 valuation
4.3 Development of the company after the IPO

5. Past IPOs of sport companies and their development
5.1 Williams Grand Prix Holdings Plc
5.2 Manchester United Plc
5.3 Lessons learned

6. Conclusion



Index of Abbreviations

illustration not visible in this excerpt

Table of figures

Fig. 1: DCF methods

Fig. 2: Exchange segments on the German stock exchange23

Fig. 3: Formula 1 company structure

Fig. 4: Ownership overview

Fig. 5: Turnover Formula 1 in million dollars.

Fig. 6: Four main sources of Formula 1’s turnover in

Fig. 7: CVC Funds

Fig. 8: Stapled security structure

Fig. 9: Singapore Exchange public float

Fig. 10: Formula 1 P/E ratio

Fig. 11: Stock chart Williams Grand Prix Holdings Plc

Fig. 12: Stock chart Manchester United Plc

Index of Appendices

Appx. 1: IPOs proceeds 2008

Appx. 2: IPOs proceeds 2013

Appx. 3: Initial returns in German IPOs

Appx. 4: Initial returns for 51 countries

Appx. 5: Exchange listings

Appx. 6: Underwriter spreads

Appx. 7: Credit ratings

1. Introduction

1.1 Background and motivation

The decision to go public is decisive for the future of a company. The owners of the company have to weigh the advantages and disadvantages that a potential initial public offering (IPO) may entail for the firm. As the decision to go public or stay private has impact on almost all levels and departments of the company, it is advisable to have the backing of all shareholders.[1]

Shares are no recent invention, actually the first share dates back to 1288. The share certified one-eighth of the Swedish copper mine Falun. The company still exists today under the legal name Stora Kopparbergs Bergslags Aktiebolag. Vereinigte Ostindische Kompanie was the first European company to be listed on a stock exchange in 1602. The first German share was Dillinger Hütte in 1809. The company still exists, and has approximately 5,000 employees.[2]

More than 200 years later, in 1996, Deutsche Telekom was listed on the German stock exchange. This is considered to be a landmark, as the public interest in shares increased significantly, due to that IPO.[3] In the years prior to 1996, there were 15 IPOs in 1994 and 20 IPOs in 1995. After the Deutsche Telekom IPO, the interest in shares from private as well as institutional investors increased materially, which is proven by the fact that 36 IPOs in 1997, 79 in 1998 and 175 in 1999 were accomplished. The 175 IPOs in 1999 mark the peak of new companies going public in Germany. The burst of the internet bubble in 2000 slowed down the IPO market. As the market environment is important for companies which consider a listing, many shied away in the following years and, in 2003, Germany experienced a low, with zero IPOs. Due to an improvement in economic conditions, the market picked up again and, in 2013, there were six IPOs in Germany.[4]

Although shares have gained popularity since 1996 – following the Deutsche Telekom listing, empirical evidence proves that both German investors and German companies do not use the equity market as much as those of other countries – for example, the UK and the USA. Only 7% of the German population has invested in shares, compared to 18% in the UK, and 21% in the USA.[5] Another factor which proves the difference in the usage of the stock market to raise equity is the total number of listed domestic companies. In Germany, 665 companies are publicly listed, compared to 2,179 in the UK, and 4,102 in the USA. When the market capitalization as per cent of the global domestic product is compared, it can be seen that the UK has a market capitalization of 122.2% of their GDP, the USA has 114.9%, and Germany only 43.4%.[6]

The at international level comparatively small number of public listed companies and low market capitalization – as percentage of the GDP – show that only few German companies already use the equity market to raise equity. The consequence is that German companies have a lower equity ratio.[7]

Before a company is listed on a stock exchange – regardless of in which country, many key steps have to be considered. The shareholders of the company have to take into account the advantages and disadvantages that the public listing may have. Investment banks, advisers, and auditors have to be hired in order to evaluate the company. One of the most challenging aspects during the IPO process is the pricing of the shares. The different interests of the underwriter, investor, and issuer have to be balanced. One phenomenon which often appears on the first day of trading is underpricing. A share is underpriced if its price on the secondary market is higher than that at which it was sold at the IPO in the primary market.[8]

The motivation to write this thesis is to do scientific research on the Formula 1 and figure out the reasons that the issuers might have for a public listing, and why Singapore is the most likely stock exchange for the listing.

1.2 Research question

The Formula 1 has a complicated ownership structure, which consists of many companies and different owners. What is the reason behind the potential IPO? Why do the current owners of the Formula 1 plan to have their company listed on a stock exchange? Do they need to raise equity to develop the business, or does the majority owner – the venture capital company CVC Capital Partners – aim to sell its shares for the highest possible price and exit their Formula 1 investment? In 2012, a listing on the Singapore stock exchange was planned but suspended. What were the reasons behind the suspension of the IPO? Why is the Formula 1 aiming at a public listing in Singapore and not on any other stock exchange in the world? When a company goes public, there are various motives, but what are the specific motives of the current Formula 1 owners in deciding to go public? Have the owners decided to obtain an increase in capital with the IPO, or are the owners simply selling their shares? Another interesting aspect which is discussed is the future development of the company after an IPO.

1.3 Procedure

The aim of this thesis is to analyze a potential Formula 1 IPO critically. In the first chapter, the theoretical basis of IPOs is explained. A definition of IPOs is given, after which the different parties involved in an IPO are discussed. Then the key steps of the IPO process are outlined. Another important element of this chapter is the fundamentals of IPO price determination. The focus is on the company valuation, the process of price determination, and the phenomenon of underpricing. Different major stock exchanges are named and the exchange segments are discussed – with a focus on Germany. The chapter ends by naming the advantages and disadvantages of a public listing. The second chapter is about specific aspects of the Formula 1. After a brief description of the history of the Formula 1, the ownership structure is analyzed.

After this, the economic standing of the Formula 1 is discussed – with the focus on the four major areas of income, sponsoring, race fees, corporate hospitality, and television rights.[9] Then the future opportunities of, and threats to the Formula 1 are compared. In the third chapter, which is about the going public of the Formula 1, first the motives and incitements for going public are discussed – from the issuer’s and the investor’s perspective. The technical details of the IPO are then analyzed, with the focus on the choice of the stock exchange, share structure, market environment, requirements, and the Formula 1 valuation. The chapter ends with consideration of the development of the company after the IPO. The fourth and last chapter of the thesis is about past IPOs of sports companies and their development. The Williams Grand Prix Holdings Plc and Manchester United Plc have been chosen for further analysis. These companies show similarities with the Formula 1, as a major part of their income is also generated through sponsoring and television rights. Finally, the lessons learned from those IPOs are pointed out, in order to show if there are some opportunities of improvement for the Formula 1.

2. Theoretical framework

2.1 General framework

2.1.1 Definition of IPO

“An IPO is the first sale of a company’s shares to the public and the listing of the shares on a stock exchange.”[10] The process of going public can be defined in three constitutive elements. First, there is the change of the legal form of the company to a public limited company. If the legal form of the company is not already a public limited company, this is a prerequisite for an IPO. The second step is the IPO. This typically leads to an increase in capital stock.[11]

The exception is an IPO where the company does not require more capital, and decides to sell only shares from previous owners. This is called reallocation. Depending on the percentage of stock sold on the exchange, the distribution of power will change.[12]

If the previous shareholders keep the majority of the shares, they demonstrate that they believe in the future of the company. On the other hand, the minimum flotation should be at least 25% in order to show investors that they are willing to allow a qualified minority.[13]

The last step is the listing of the shares on a stock exchange. A functional secondary market where shares can be traded is decisive for the desirability of shares as an investment opportunity.[14]

IPOs are an important vehicle for companies to raise equity. This is shown by the fact that the government supports companies which want to go public. On the 1st of May 1987, the German government established the regulated market, in order to support medium-sized and small companies when trying to raise equity through the stock market.[15]

2.1.2 Involved parties

When a company goes public, a number of different parties are involved. As most companies do not have all the required expertise within their company, external parties are hired. In addition to the investment banks, the parties involved in an IPO are lawyers, tax advisers, auditors, public relations agencies, issuers, and investors. The lawyers advise the company with regards to the change of the firm into a public limited company. Another function is the preparation of contracts for an employee participation program. On the other hand, the lawyers are responsible for paying attention to the complex regulations of a stock exchange listing, as well as for minimizing the liability risk of the issuers.[16]

The responsibility of tax advisers is mainly focused on the judgment of the fiscal effects and their optimization. Auditors cooperate with the internal accounting department of the respective companies and are responsible for the preparation of financial documents, as well as for company valuation to support the management in bank negotiations.[17]

Depending on whether they have measured up to the challenges which arise with an IPO, auditors who are already known by the company may be used, or a new auditor is chosen.[18]

The significance of public relations agencies in Germany has increased in the past years. The competition to attract investors has become fiercer, thus companies have realized the importance of marketing their company. The duty of the PR agencies is to analyze the company, products, industry, and competitors. An image campaign is then developed and conducted by the PR agencies. As the corporate image of a company is important for a successful IPO, a PR agency should be hired in the early stages of the IPO process.[19]

The issuers are the owners of the company, who initiate the IPO. Depending on the aim of the issuers, they sell either only their own shares, or they also raise new money with an increase in share capital. In both cases, it is in the issuers’ interest to sell their shares at a high price. The issue price should not be too high, in order for the investors to have a positive performance of the share. With a positive performance, future increases of capital are more likely to be successful.[20] A fair issue price shows the investors that the issuers are willing to let the investors participate in the success of the company.[21]

Prior to the IPO, there is often no other information than that given in the prospectus available for potential investors. Investors require information about the company, in order to evaluate the firm properly. It is expensive for them to evaluate the company and come up with a decision on whether to invest. Therefore, some form of compensation must be offered in order to convince investors to make the effort. The assumption is that investors are compensated by intentional underpricing. This phenomenon will be discussed in depth later in chapter Underpricing.[22]

Investors want to maximize their profits through the subscription of shares. They aim to at least outperform alternative investment opportunities with the same risk profile. IPOs are often small in size, and the companies concentrate on one specific product or industry. This can be used by investors to diversify their portfolio or invest in shares which are dependent on specific influencing factors.[23]

One crucial decision which the issuers have to make is the appointment of the investment bank. The investment bank is not only responsible for the placement of the shares, but also for the coordination of the entire going public process. Therefore the issuers typically have a ‘beauty contest’, at which the potential investment banks present themselves. Based on criteria, such as the expertise, reputation, costs, and the first indication of the valuation which the issuers receive from the investment banks, they decide which one they choose to be their lead manager.[24] IPOs typically have a high relevance within investment banks. This is due to the reputation which comes with the placement of a major company, such as Facebook, as well as the profitability.[25]

Empirical studies prove that investment banks with good reputation have less underpricing as well as a better long run stock performance. This is an advantage for the issuer, as the total proceeds from the IPO are higher when there is less underpricing. The advantage for a potential investor is an above-average long-run stock performance.[26] Another vital aspect for investment banks is the ‘league tables’. League tables are rankings of investment banks in a specific business. For example, the 2008 IPOs global league table (see Appendix 1 IPOs proceeds 2008) is a ranking of investment banks based on their IPOs proceeds in 2008.[27] If this table is compared with a more current league table from 2013, it can be seen that the top investment banks are similar to the ones 5 years ago (see Appendix 2 IPOs proceeds 2013).[28]

Investment banks place a lot of importance on league tables, as they are an effective marketing tool – and issuers also base their decision as to which investment bank they use on these.[29]

The number of investment banks which operate in the market also depends on the market situation. If this is good, the number of investment banks – and therefore the competition – increases, with a temporal delay.[30]

The investment bank and the issuer have to make a decision on the allocation of competences. Particularly important are the decisions regarding the issue price, number of shares placed, and the allocation of the shares.[31] With regards to the allocation of shares, the issuer has not to consider any legal constraints. The issuer is allowed to place the shares with the investor whom he considers best.[32]

The underwriting by the investment bank can be divided into three different categories. The first one is the best effort contract. The investment bank does not accept any responsibility to take over any shares which were not sold. The shares remain with the issuer who must then decide on the future use. The second option is the firm commitment contract. The investment bank is obliged to buy those shares which were not sold to investors. The last possibility is the stand-by contract. The investment bank takes over the entire issue volume before it is sold to the investors. If the issuer prefers a guarantee that the investment bank will take over shares which were not sold during the IPO, the fees charged by the banks are higher.[33]

Investment banks receive remunerations from the issuer. The remuneration package can be structured in different ways. Provisions, shares, share options, and specific preferences are very common. Provisions can be either a fixed amount or a percentage of the issue volume. Shares are either sold or transferred, free of payment, from the issuer to the investment bank. The investment bank can benefit if the price of the shares are moving up. The decisive factor is the price at which the shares are bought. Share options provide the investment bank with the right but not the obligation to buy shares of the issuer at a fixed price. The investment bank buys the shares if the price of the shares is higher than the initial price of the option. The last remuneration is a specific preference – this is, for example, the commitment of the issuer to use the investment bank again for future placements.[34]

Typically, it is not just one investment bank which is managing the IPO. Issuers select a lead manager, and the lead manager – in consultation with the issuer – forms a syndicate of banks. The syndicate is formed in order to assist the lead manager in pricing, underwriting, and distribution of the offer. Upon completion the syndicate is dissolved.[35]

The syndicate is generically divided into three components: the managing group, the underwriting group, and the selling group. The managing group consists of the lead manager and other co-lead managers. The lead manager is in charge of the necessary diligence, the roadshow, book-building, and allocation of the shares. Therefore the lead manager receives the largest portion of the remuneration. The underwriting group is composed of the managing group and non-managing underwriters. Non-managing underwriters are typically called managers, and underwrite part of the shares. The part of shares underwritten by the managers is determined by the managing group. Finally, there is the selling group, which consists of so called co-managers. The co-managers put their best efforts into selling the shares, but they do not underwrite shares. This means they do not take any risk. The number of banks in a syndicate depends on the tranche. The retail tranche is usually more crowded, with up to 20 co-managers in the selling group. Whereas the institutional tranche consists of 4 to 6 banks and rarely has a selling group.[36]

An additional service offered by the lead manager is often the price support and market making commitment. Price support refers to the fact that the lead manager buys shares as soon as they drop below the issue price. The lead manager, as well as the issuer, is interested in a positive performance of the shares. Market makers facilitate trading in securities. They display bid and sell quotations for the security and therefore keep the market liquid.[37] The beneficiaries of the price support provided by the lead manager are the regular investors.[38] The market making by the lead manager is important in the beginning and declines in importance afterwards.[39]

2.1.3 Main elements and key steps of the IPO process

The key steps of a typical IPO process can be divided into four main phases: preparation, approaching the market, going public, and post-IPO.[40]

In the preparation phase, the owners of the company decide to make the company public. This is usually done after a thorough process, in which the advantages and disadvantages of an IPO have been discussed and analyzed. This process may take months, or even years, before the decision to go public is taken.[41] The company prepares the internal accounting system to produce financial statements for the shareholders. It is advisable that an executive with experience in IPOs is hired.[42] If necessary, the legal form has to be changed – this is also done in the preparation phase. These and other procedures are carried out in order to prepare the company for a successful IPO.[43]

The second phase is approaching the market. Once the decision to go public has been taken, the company recruits specialists who assist the company in the IPO. Typically, a lawyer, auditor, public relations agency, and one or more investment banks are hired. The number of investment banks varies, depending on the issue volume. If more than one is used, it is said to be an underwriting group. The underwriting group is responsible for placing the shares on the market. In most cases, the firm commitment is used, this means that the underwriting group absorbs the entire risk in placing the shares. The company also has to decide regarding the stock exchange listing. It is possible to get a domestic or foreign listing. Another aspect is the exchange segment. Depending on the publication and admission requirements, the issuer can choose different exchange segments. The reputation of the segment grows with the publication requirements.[44] Furthermore, the equity story is prepared. This is important to market the company to potential investors during the roadshow. This is done either to an audience of investors, in small groups, or in one-on-one meetings for the most important investors.[45]

The roadshow usually takes a couple of weeks. It depends partly on the size of the IPO. A small European IPO might just have a roadshow of one week, whereas a large IPO might have a roadshow of two weeks, one in Europe and one in the USA.[46]

Often a due diligence is done by the lead underwriter. The results can be used to put together the preliminary prospectus. Moreover, an IPO report is published which also includes the company valuation and a forecast of the business performance. An underwriting agreement is signed by the issuer and the investment bank. The terms agreed on in this document are the commitment of the investment bank to take over the shares which were not sold, the issue price of the shares, the closing conditions, the remuneration of the investment bank, the liability for the offer prospectus, the price management after the IPO and lock-up agreements. The price determination process is also a part of this phase. The issuer has to decide between the fixed-price issues and the book-building issues. In the fixed-price issue, the issue price of the company is given before the market demand is known. As the market demand is not yet known, it is difficult to set the price – and it may be too high or too low. If the investment bank has signed to take over the shares which were not sold, they opt for a low issue price. Due to this and the fact that it is not possible to react if market conditions change, the fixed-price is now not used often. The book-building uses the market demand to set a price range at which the shares are offered.[47]

During the roadshow, institutional investors are asked to place non-binding bids in order to get a feeling for the market demand and price. As soon as the investment bank has collected enough information to set a price range, the book is closed and the retail offer begins. In this way, the investment bank has set a price range where they can be confident that there is enough market demand and they can also react on changing market conditions, as the price ranges between 10% and 20% from the mid-price.[48]

In the going public phase, the price of the share is set. This is done as soon as the book- building period is finished and the book is closed. The price is set in the so-called price meeting. The issuer usually wants to maximize profits and have a price at the top of the price range, the investor wants to make a good bargain, and the investment bank is in between. Depending on their remuneration package, they may also have their own interests in mind.[49] The price is typically set at a level where the demand is higher than the supply. The shares have to be distributed between the investors. The issuer prefers a broad distribution of the shares. This eases a possible future capital increase and the influence of the shareholders is less. The investment bank likes to distribute the shares as conveniently as possible and also has relationships to institutional investors in mind. Therefore they would like to distribute the shares to just a few institutional clients. A distribution which is not considered as fair might have a negative impact on the investment banks reputation. For this reason, it is important that the distribution is done in a transparent and fair manner.[50] European IPOs usually price within the price range. On average, less than 20% of IPOs price outside the range – in contrast to IPOs in the USA where roughly 50% are priced outside the price range. This is most probably the case because there is a sharper focus on the price range in Europe than in the USA.[51]

Once all shares have been allocated, trading on the stock exchange begins. The positive difference between the price of the share on the stock exchange and the issue price is called underpricing. Underpricing can be especially high in hot issue markets.[52]

The last phase is the post-IPO phase. The investment bank which was responsible for the IPO still has responsibilities after the company has been listed on the stock exchange. At first, the investment bank provides price support.[53] The first few days of trading are volatile – this is due to the fact that investors who may have speculated on an underpriced IPO sell shares in order to realize profits. On the other hand, investors who did not receive shares and want to hold investments in the company buy shares.[54]

The share is also going to experience volatile trading and probably a decline in the share price on the day the lock-up period ends. This is typically 12 to 24 months after the IPO. After this, the company is traded on the stock exchange like any other share, and there are no longer any special conditions to be considered. The issuer has to face the challenge of meeting the investors’ expectations. It is best if the information collected during the IPO is maintained and updated. It is advisable to implement an investor relations department within the company in order to stay in touch with institutional investors.[55]

2.2 Fundamentals of IPO price determination

2.2.1 Company valuation IPO

The determination of the company value is one of the most important and complex elements during an IPO. The issue price of shares should represent a fair value and must be comprehensible.[56] If mature companies of established markets go public, the valuation is characterized by uncertainties – and this is even more the case when a company from the new economy has to be valued.[57] The proceeds which the company receives from the IPO depend primarily on the company valuation. The two most common methods of valuating a company prior an IPO are the discounting methods and the comparable multiples. The parameters used in the valuation methods are not fixed and absolute. They are rather predicted, and are subject to uncertainties. Therefore the company value calculated by different parties might differ. Whereas the company valuation is typically done by tax advisers or auditors, the valuation prior an IPO is done by the responsible investment bank. The investment bank’s aim is to evaluate the company at a high but realistic level. The interest in a realistic valuation of the company is even more important if the investment bank has agreed to a firm commitment with the issuer – which implies that, if not all shares are sold to investors, the investment bank has to take over the remaining shares from the issuer.[58]

The actual company value depends on the valuation method. There is not only one valuation method which is considered as being correct. Actually, there are different methods which can be used, depending on the purpose of valuation.[59]

The investors judge the companies listed on the stock exchange mainly by their profitability and future cash flows. Because of this, valuation methods which refer to the net asset value are not of major relevance for an IPO company valuation.[60]

The discounting methods can be separated into the entity method and the equity method. The entity method is again divided into the weighted average cost of capital (WACC) approach, the total cash-flow approach, and the adjusted present value (APV) approach. The future free cash flow (FCF) which is calculated is the amount of cash not required for operations or reinvestment.[61] The process of valuing a company using the discounted cash flow (DCF) method is separated into different stages. First, the future free cash flows (FCF) for the next five to ten years are calculated. Then the discount rate, the WACC is calculated – for the discount of all future FCFs. After this, the terminal value (TV) is identified. The TV is the net present value (NPV) of all future cash flows which accrue after the five to ten years which were calculated. Finally, the net present values of the cash flows are summed up and the TV is added. The WACC approach and total cash-flow approach use the free cash flow to the firm – which is the cash flow that is available to debt- and equity holders. The only difference between the WACC approach and the total cash-flow approach lies in where the tax shield is taken into account. The total cash-flow approach takes the tax shield in the free cash flow calculation into account. It increases the total cash flow, and therefore can be disregarded once the WACC has been determined. The WACC approach uses the tax shield in the opposite way. The WACC approach is considered to be the standard model for company valuation and is used in most cases for the evaluation of companies before they go public.[62]

The APV approach which also counts as an entity method, calculates on the basis of the company’s free cash flows – assuming pure equity financing and adding the present value of any financing side effects, such as the tax shield.[63] In a general sense, it can be said that the APV is based on the principle of value summation.[64]

The equity method uses the cash flow to equity as basis for the calculation. In this method, the equity value is calculated directly. Compared to the WACC approach, the cash flows of the equity method take into account the payments between the company and the debt capital lender as well as the tax shield effect of the debt capital.[65]

The chart below shows the different DCF methods discussed above.

illustration not visible in this excerpt

Fig. 1: DCF methods.[66]

The second method is using comparable multiples. This valuation method is one of the favorites – used by investment banks, especially for IPOs. The method is relatively easy to apply and uses fewer assumptions, compared to the DCF methods. The company is compared with other firms which have the same fundamental characteristics, such as risk, growth prospectus, profitability, and which come from the same industry. Multiples, such as the price-earnings (P/E) ratio, are used to draw conclusions as to the value of the company. The other multiple which is used quite frequently is the price-to-sales (P/S) ratio. There are no rules as to how the compared firms are selected, but there are some common approaches. The first is to select as many firms as possible from the same industry and calculate the group’s median multiple. The second is to choose a direct competitor which is probably most similar to the company. The IPO prospectus typically names the competitors of the IPO candidate. The last option is to use companies which have recently gone public, as a comparison.[67]

A comparison between the discounting methods and the comparable multiples leads to the conclusion that the DCF methods are more complex. In addition, the comparability is not visible as one figure, as it is with the multiples P/E ratio. The advantage of the DCF methods is the fact that not just the situation in a specific year is analyzed. The cash flow is calculated looking forward, whereas the multiples compare companies on the basis of numbers – such as the P/E ratio – from the past.[68]

Another downside of the multiples is that enough similar companies have to be listed on the stock exchange in order to get the data. This is often only the case in major markets, such as the USA, UK, and Germany. Finally, the firm-specific risk is not taken into account in the comparable multiples method.[69]

The comparable multiples are often used for a rough reference value, but the investment bank also calculates the company value using the DCF approach. The calculated company value is then often reduced by a specific amount, in order to give the investors an incentive to invest. The extent of the deducted amount depends on the market situation and the field in which the company is engaged.[70]

2.2.2 IPO pricing Process of price determination

One major factor for successful floating of shares is fixing of the correct issue price. The issue price depends very much on the company valuation. Another aspect which influences the issue price is the price-setting mechanism chosen by the issuer and its investment bank. The three main mechanisms used are: fixed price, open price (book-building) and auctions.[71]

The fixed-price offer was the most often used price-setting mechanism in Germany until 1994. The investment bank offers the shares at a fixed price, based on the results of the company valuation which they have conducted. Sometimes institutional investors are approached to get a feeling for the market demand, but generally the price is fixed before the market demand is known or evaluated. The real market demand is not known before the issue price is fixed – which may lead to an incorrect assessment of the price.[72]

If the investment bank has agreed to a firm commitment, the issuer has the advantage that the issue volume is already known in advance. Thus old investors who sell their shares already know exactly how much money they will get for these.[73]

The investment bank has the entire risk of a successful placement of the shares. Therefore they will opt for a markdown of the calculated issue price during the company valuation. This can be seen as a safety margin in order to make sure all shares are sold. Due to the fact that it is difficult to come up with the “correct” issue price, it is almost impossible for the issuer and the investment bank to maximize profits. Another disadvantage of the fixed-price offer may arise if not all shares were sold to investors. The investment bank has the obligation to take over the shares from the issuer. This adds pressure on the market price of the share from the first trading day – but if the market demand is higher than the number of shares available, allocation needs to be on a pro rata basis. This leads to a volatile share performance and an unsatisfied issuer as the underwriting revenue could have been higher.[74]

The second price-setting mechanism is the open-price offer (book–building). The book-building is the mechanism which is used most frequently for pricing IPOs.[75] The major difference to the fixed-price offer lies in the inclusion of the institutional investors in the price determination process and the close connection to the IPO marketing phase.[76] A company valuation is conducted the same way as in the fixed-price offer. After the company valuation, the investment bank reaches out to institutional investors. The institutional investors give, on the basis of the company valuation, their price assessment in the so-called pre-marketing-phase. Based on this information, the investment bank sets a price range which is typically between 10% to 20% from the mid-price. The investment bank, together with the issuer, then visits institutional investors in order to present the company. After this, the book-building period starts. It typically lasts between two to ten working days. During this period, investors have the opportunity to submit their bids. All bids are collected in an electronic order book. The issuer and investment bank receive information about the investors, such as name and origin. This is valuable information which can be used for the allocation of the shares at a later date. After the book is closed, the issue price is determined. The aim is to decide on a price, at which all shares are placed – and this price is at the top end of the price range.[77]

Under certain circumstances, the issuer may choose a lower price in order to obtain a better share distribution. Impressions, gained by the issuer during the roadshow – such as the strategic focus of the investors – may also be considered. The distribution of shares to private investors is typically done in a different manner, as the private investors are not known. The principle of indiscriminate all-round distribution is most often chosen.[78] The allocation rules for private investors have to be published.[79]

Due to the inclusion of the investors in the price determination, the market demand for the shares is considered before an issue price is set. This leads to higher underwriting revenue for the issuer. In addition, the placement risk for the issuer and the investment bank is reduced.[80] The issuer can also react to new market conditions, as the issue price is flexible.[81] Another flexibility which the book-building offers the issuer is the over-allotment option. This is also called ‘greenshoe’, after the first company which used this option. It is an instrument which is used for active market-making by the investment bank.[82] The investment bank has the option to buy additional shares from the issuer at the issue price. The size of the greenshoe is typically at around 10% to 15% of the issue volume. The option is used by the investment bank if the market demand is higher than the number of shares available.[83] Granting a greenshoe option is standard practice in the capital markets today.[84] As a possible disadvantage, the uncertainty of the total underwriting revenue can be named. Compared to the fixed-price offer, where the total underwriting revenue is known from the start, when book-building is chosen, this amount is first known when the issue price has been determined. Another aspect is that book-building imposes higher requirements on the investment bank and the issuer – for example talks have to be held with potential institutional investors.[85]

The last price-setting mechanism is the auction. The auction is not used very often in the price-determination process. In Germany, there have been only few IPOs where this mechanism has been used, for example the Trius AG in 2000.[86]


[1] See Eckbo (2007) p. 378.

[2] See Czycholl (2011).

[3] See Neuhaus (2007) p. 1.

[4] See Statista (2014).

[5] See Korn (2000) p. 51.

[6] See The World Bank (2013).

[7] See Schanz (2000) p. 1 – 3.

[8] See Ernst & Young (2011).

[9] See Ruhkamp (2013).

[10] Iannotta (2010) p. 45.

[11] See Oettingen (1990) p. 7.

[12] See Oettingen (1990) p. 7.

[13] See Herdt, Padberg and Walther (1988) p. 22.

[14] See Oettingen (1990) p. 8.

[15] See Deutscher Bundestag (1985) p. 10.

[16] See Schanz (2000) p. 188.

[17] See Draho (2004) p. 28 – 29.

[18] See Schanz (2000) p. 188 – 189.

[19] See Schanz (2000) p. 190 – 192.

[20] See Weinberger (1995) p. 60 – 63.

[21] See Weinberger (1995) p. 355.

[22] See Draho (2004) p. 28 – 29.

[23] See Steib (2005) p. 155 – 157.

[24] See Steib (2005) p. 147 – 149.

[25] See Habersack, Mülbert and Schlitt (2005) p. 40.

[26] See Vogt (2005) p. 56 – 57.

[27] See Iannotta (2010) p. 8 – 9.

[28] See Reuters (2013).

[29] See Iannotta (2010) p. 8 – 9.

[30] See Lorenzat (2008) p. 217 – 221.

[31] See Lüdiger (2007) p.19.

[32] See Kruppe (2008) p. 2.

[33] See Lüdiger (2007) p. 19 – 20.

[34] See Lüdiger (2007) p. 21 – 25.

[35] See Iannotta (2010) p. 60 – 62.

[36] See Iannotta (2010) p. 62 – 64.

[37] See Eckbo (2007) p. 247 – 249.

[38] See Ljungqvist, Nanda and Singh (2001) p. 29.

[39] See Eckbo (2007) p. 247 – 249.

[40] See Nevries (2006) p. 13.

[41] See Lenoir (2004) p. 12 – 13.

[42] See Draho (2004) p. 182.

[43] See Lenoir (2004) p. 12 – 13.

[44] See Nevries (2006) p. 30 – 32.

[45] See Lenoir (2004) p. 14 – 15.

[46] See Iannotta (2010) p. 53 – 54.

[47] See Lenoir (2004) p. 16 – 17.

[48] See Iannotta (2010) p. 54.

[49] See Iannotta (2010) p. 55.

[50] See Lenoir (2004) p. 19 – 20.

[51] See Iannotta (2010) p. 55.

[52] See Nevries (2006) p. 40 – 41.

[53] See Lenoir (2004) p. 20.

[54] See Nevries (2006) p. 42 – 43.

[55] See Nevries (2006) p. 42 – 43.

[56] See Blättchen and Jasper (1999) p. 49.

[57] See Koch (2003) p. 3 – 4.

[58] See Schanz (2000) p. 203 – 205.

[59] See Moxter (1983) p. 6.

[60] See Schanz (2000) p. 203 – 205.

[61] See Brealey, Myers and Allen (2006) p. 998.

[62] See Steib (2005) p. 206 – 213.

[63] See Brealey, Myers and Allen (2006) p. 993.

[64] See Luehrman (1997) p. 135.

[65] See Steib (2005) p. 206 – 213.

[66] Own illustration.

[67] See Draho (2004) p. 158 – 162.

[68] See Koch (2003) p. 13 – 15.

[69] See Draho (2004) p. 160 – 163.

[70] See Blättchen and Jasper (1999) p. 49 – 51.

[71] See Schanz (2000) p. 308 – 310.

[72] See Bosch and Groß (2000) p. 164 – 166.

[73] See Schanz (2000) p. 308 – 310.

[74] See Schanz (2000) p. 308 – 310.

[75] See Jakob (1998) p. 105.

[76] See Jakob (1998) p. 151.

[77] See Schanz (2000) p. 310 – 313.

[78] See Korn (2000) p.97 – 98.

[79] See Kruppe (2008) p. 8.

[80] See Schanz (2000) p. 313 – 315.

[81] See Ehlers and Jurcher (1999) p. 111.

[82] See Blättchen and Jacquillat (1999) p. 177.

[83] See Schanz (2000) p. 322 – 325.

[84] See Habersack, Mülbert and Schlitt (2005) p. 55.

[85] See Schanz (2000) p. 313 – 315.

[86] See Habersack, Mülbert and Schlitt (2005) p. 54 – 55.


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critical formula



Title: Critical analysis of a potential Formula 1 IPO