The valuation effects of unit versus share‐only IPOs

• Published date: 01 October 2021
• Author: Mengxi Chen
• Date: 01 October 2021
• DOI: http://doi.org/10.1002/jcaf.22511

Received: 25 May 2021Accepted: 7 July 2021

DOI: 10.1002/jcaf.22511

RESEARCH ARTICLE

The valuation effects of unit versus share-only IPOs

Mengxi Chen

Department of Finance, Central

Connecticut State University, New

Britain, Connecticut, USA

Correspondence

MengxiChen, Department of Finance,

CentralConnecticut State University, 1615

StanleySt, New Britain, CT 06050, USA.

Email:mengxi.chen@ccsu.edu

Iwould like to thank Jack Cooney for his

invaluablehelp and comments and semi-

narparticipants at Texas TechUniversity

andCentral Connecticut State University.

Anyremaining errors are my own.

Abstract

Units consist of shares and warrants. Some firms issue units in initial public

offerings (IPOs) after which warrant holders can exercise warrantsand purchase

shares from the issuer.Why do firms choose to issue units instead of only shares?

I answer this question based on Merton’sinvestor recognition model. Firms lack-

ing pre-IPO publicity can benefit from an increase in investor recognition. I

find that unit firms have less pre-IPO publicity than share-only firms. Separate

trading between warrants and shares and eventual exercise of the warrants will

increase the number of shareholders and therefore firm value.

KEYWORDS

firm value, initial public offerings, investor recognition, unit offerings, warrants

JEL CLASSIFICATION

G24, G32

1 INTRODUCTION

A unit offering is an offering composed of a combination

of common shares and long-term warrants to purchase

common shares. From 1996 to 2016, 8.4% of initial public

offerings (IPOs) in my sample were classified as units.

However, despite their prevalence, few academic studies

examine unit offerings and most specifically exclude unit

offerings from their sample.1A representative example of a

unit IPO offering was made by Xybernaut Corporation on

July 18, 1996. There were 2.1 million units offered at a price

of $5.50 per unit. Each unit was composed of one share of

common stock and one warrant. Each warrant authorized

its holder to purchase one share of Xybernaut Corporation

common stock at $9, starting from the issue day until July

17, 1999 (i.e., 3 yearsafter the issue date). Starting 18 months

after the offering, the company was allowed to redeem the

warrants at a price of $0.05 if the common stock closing

price was equal to or higher than $18 for 20 consecutive

trading days. The units, common stock, and warrants in

this offering were listed on NASDAQ and investors could

separately trade each of these three securities (the shares,

the warrants, and the units) immediately after the offering.

Studies exclude unit offerings from analyses probably

because adding warrants makes unit offerings fundamen-

tally different from share-only offerings. However,as men-

tioned earlier,unit offerings are not a minor part of the IPO

market. My main research question centers on why firms

choose to issue warrants along with common stock. Prac-

titioners believe that warrants function as “sweeteners” in

the offerings to induce investors to buy shares of firms

that receive little attention from the public (e.g., Business

Week [May 13, 1991]). Academics, on the other hand, have

focused on two theories for the use of unit offerings: the

“agency cost” theory proposed by Schultz (1993) and the

asymmetric information theory offered by Chemmanur

and Fulghieri (1997). According to Schultz’s (1993)agency

cost theory, unit offerings solve the free cash flow agency

problem in IPOs through the use of staged financing. Rais-

ing all the cash necessary to finance a new project at the

IPO stage leads to managers possibly squandering money

if the project turns out to have a negative net present value

(NPV). Warrants are therefore used to raise the additional

funds only if the project is proven valuable, as evidenced

by an increase in stock price. On the other hand, the infor-

mation asymmetry theory proposed by Chemmanur and

J Corp Account Finance. 2021;32:7–26. © 2021 Wiley Periodicals LLC7wileyonlinelibrary.com/journal/jcaf

8CHEN

Fulghieri (1997) argues that insiders with private informa-

tion use the portion of firm value sold as warrants as a

signal of firm quality. In an equity market characterized

by information asymmetry and to maximize the expected

utility of firm insiders, firms having high expected cash

flows and high riskiness would cut back on retained equity

ownership and underpricing by increasing the portion of

firm value sold as warrants. This happens especially when

they find that employing the signal of retaining equity and

underpricing becomes relatively more expensive as firm

riskiness increases. However, it is costly for firms having

low expected cash flows to mimic this signaling package.

In a separating equilibrium, the most effective signaling

strategy turns out to involveretaining equity, underpricing,

and adding warrants. Therefore, according to Chemmanur

and Fulghieri (1997), only firms that have high expected

cash flows and very high risk issue units while low-risk

firms issue equity alone.

Several studies have tested these two theories. Some

findings are supportive of one theory but not the other

(How & Howe, 2001; Lee et al. 2003) and some cannot

be fully explained by these two theories (Byoun, 2004). In

this paper, I offer a third explanation for whyissuing firms

utilize the unit offer method based on the investor recog-

nition hypothesis in Merton (1987). Merton assumes that

when investorsconstruct their portfolios, they would select

certain security only if they are aware of this security. My

explanation relies on the fact that unit offerings are a com-

bination of common stock and warrants that are separable

and tradable after the offering. Under the assumption that

some investors will sell one security and keep the other

or sell both securities to different investors, this would

lead to a mechanical increase in the firm’s investor aware-

ness compared to similar offerings that sell only common

stock. This assumption of trading fragmentation of war-

rants and shares can be reasoned by findings in Ami-

hud et al. (2003).2Further, according to Merton (1987), an

increase in investor awareness should increase firm value.

Even though issuing units can increase firms’ investor

awareness and therefore firm value, it may not be the best

choice for all IPO firms. There are several possible reasons

for firms not to issue units. First of all, Merton’s model

implies that the marginal benefit of increasing investor

awareness is diminishing as the number of investors

increases3and Merton also assumes that the marginal

cost of increasing investor awareness increases with the

number of investors already informed. In other words,

as the investor awareness increases, bringing an extra

investor would benefit the firm less but cost the firm more.

Companies would try to raise their investor awareness

until they reach the equilibrium where the marginal

benefit equals the marginal cost. Large and matured IPO

firms (e.g., Twitter, Facebook) should have more publicity

already before their IPOs. For these firms, the marginal

cost of increasing investor recognition through issuing

warrants may outweigh the marginal benefit of doing

so. Therefore, a further increase in investor awareness

is not in the best interests of current shareholders for

these firms at the time of IPO. In addition, there are

costs associated with issuing units. When warrant holders

exercise their warrants, they purchase shares at a discount

price and become new shareholders, which could hurt

the interest of existing shareholders due to the dilution

effect.

While large and mature IPO firms may not find it opti-

mal to issue units, this might be the best choice for smaller,

younger and riskier firms, who are typically brought to

the market by low-prestige underwriters. These firms nor-

mally receive less publicity before going public. As a result,

it is worthwhile for them to try to increase their exposure

to the public as the marginal benefit of increasing investor

awareness is more than the marginal cost. As an alterna-

tive to conducting public relation events which could be

too expensive, issuing units would be the less costly/more

efficient way to increase investor awareness. In addition,

Demers and Lewellen (2003) claim that underpricing helps

IPO firms to attract market attention and create publicity.

Therefore, underpricing can be a complementary tool for

unit firms to increase investor recognition.

Correspondingly, I propose four hypotheses. First, unit

IPO issuers should have less pre-IPO publicity before the

offering. These firms may find it costly and/or inefficient

to conduct advertising and public relation events. As an

alternative, they can go public by issuing units. Second,

unit IPO firms should experience a greater increase in the

number of shareholders than comparable share-only firms

as their warrants are exercised. Third, firms issuing units

are underpriced to a greater extent as they employ under-

pricing as a complementary tool. Lastly, as investoraware-

ness increases after the offerings, unit firms have higher

firm value than comparable share-only IPO firms. Com-

pared with the sample of traditional share-only IPO firms,

unit IPO firms are on average younger and smaller. In

other words, on the firm size or age distribution of all

IPOs, unit IPOs concentrate on one tail of the distribu-

tion. Consequently, simply comparing the average num-

ber of shareholders and the average firm value of unit IPO

firms to those of share-only IPO firms can be misleading.

Therefore, I control other factors while comparing unit

firms with share-only firms, especially firm size and age.

This paper focuses on distinctions between unit firms and

“comparable” share-only firms.

The investor recognition explanation in this paper

is not mutually exclusive from the two existing theo-

ries by Schulz (1993) and Chemmanur and Fulghieri

(1997). Instead, given that some findings cannot be fully