What Is IPO Underpricing?
IPO underpricing is a phenomenon within Corporate Finance where the initial offering price of an Initial Public Offering (IPO) is set below the price at which the shares subsequently trade in the open Stock Market on their first day. When a new stock closes its first day of trading at a price higher than its IPO offer price, it is considered to have been underpriced. This difference represents a missed opportunity for the issuing company to raise additional Capital, often referred to as "money left on the table."15 Despite this, IPO underpricing is a widely observed practice and a long-standing puzzle in financial markets, benefiting initial investors who receive allocations.14 The process involves complex negotiations between the issuing firm and its Underwriter.
History and Origin
The phenomenon of IPO underpricing has been extensively documented in financial research for decades. Early academic work, such as that by Jay Ritter and Roger Ibbotson in the 1970s, confirmed the persistent existence of underpricing across various markets. Ibbotson's 1975 paper is often cited as seminal in establishing this observation, although it did not initially offer a definitive explanation for the behavior.13
Over time, various theories emerged to explain why companies and their underwriters would choose to price shares below their apparent market value. One of the earliest and most influential theories is the "winner's curse" hypothesis, which suggests that underpricing serves to compensate uninformed investors for the risk of being allocated shares primarily in less desirable IPOs.12 Another significant line of research points to informational asymmetry between the issuing company, the underwriters, and potential investors as a primary driver.11,10 Researchers at institutions like the Federal Reserve Bank of San Francisco have explored this puzzle, contributing to the rich body of literature on the subject.9
Key Takeaways
- IPO underpricing occurs when an IPO's first-day closing price exceeds its initial offer price.
- It results in "money left on the table" for the issuing company, as it could have raised more capital.
- Primary theories explaining underpricing include information asymmetry, the winner's curse, signaling, and underwriter incentives.
- Underpricing can benefit initial investors by providing immediate gains on the first trading day.
- While common, the degree of underpricing varies significantly across IPOs and market conditions.
Formula and Calculation
The extent of IPO underpricing is typically measured as a percentage return from the offer price to the closing price on the first day of trading. This calculation is straightforward:
Where:
- First-Day Closing Price refers to the per-share price at which the stock closes on its initial day of public trading.
- Offer Price is the per-share price at which the Public Company initially sells its Equity to investors before it begins trading on an exchange.
This formula quantifies the immediate return realized by investors who receive shares at the offer price and hold them until the end of the first trading day. It also represents the direct cost of underpricing to the company.
Interpreting the IPO Underpricing
Interpreting IPO underpricing requires understanding the motivations of various parties involved in the public offering process. A significant degree of underpricing often indicates strong investor demand and a successful launch, which can generate positive sentiment around the new stock. For example, a high "first-day pop" can create buzz and attract further investor interest.8
However, from the perspective of the issuing company and its existing Shareholders, substantial IPO underpricing means less capital was raised than potentially possible, effectively leaving money with the initial buyers. Investment Banks that serve as underwriters often face a conflict of interest, as they benefit from higher trading volume and satisfied institutional clients, which can be fostered by underpricing. A consistently underpriced IPO market can indicate a cautious approach by underwriters, aiming to ensure the deal's success and avoid the negative perception associated with an IPO that falls below its offer price on the first day. It reflects the delicate balance of Supply and Demand in a new issue.
Hypothetical Example
Consider a hypothetical company, "TechInnovate Inc.," which decides to go public through an IPO. After conducting extensive Due Diligence and Valuation analyses, its underwriters set the offer price for its shares at $20.00 each.
On the first day of trading, investor enthusiasm for TechInnovate Inc. is high. The stock opens significantly above its offer price and continues to climb throughout the day. By the close of the first trading day, TechInnovate Inc.'s shares are trading at $26.00.
To calculate the IPO underpricing percentage:
In this example, TechInnovate Inc.'s IPO was underpriced by 30%. This means that investors who purchased shares at the $20.00 offer price could have realized an immediate 30% gain by selling their shares at the $26.00 closing price on the first day. Conversely, TechInnovate Inc. could have potentially raised more capital had it priced its shares closer to the $26.00 first-day closing price.
Practical Applications
IPO underpricing is a critical consideration for various participants in the financial markets:
- Issuing Companies: Companies going public must weigh the potential "money left on the table" against the benefits of a successful IPO that generates positive momentum and investor confidence. A well-underpriced IPO can create a positive perception, which might be beneficial for future capital raises or secondary offerings.
- Institutional Investors: These large investors often receive significant allocations in IPOs and stand to benefit directly from underpricing. The immediate gains from the first-day "pop" contribute to their portfolio returns.7
- Underwriters: Investment banks acting as underwriters play a key role in setting the IPO price. They aim to balance the issuer's desire for maximum capital with the need to create sufficient demand to ensure the offering's success. Underwriters may intentionally underprice to manage Risk Management and foster a strong aftermarket for the stock.
- Market Analysis: Analysts and researchers study IPO underpricing trends to understand market sentiment, Valuation methodologies, and the efficiency of capital markets. For instance, the IPO of Figma in 2025 reportedly saw a significant underpricing, with shares soaring post-listing, highlighting substantial investor demand and underscoring the potential for "money left on the table."6
- Regulatory Scrutiny: High-profile IPOs with significant underpricing or alleged pricing irregularities can attract regulatory attention. The Facebook IPO in 2012, for example, faced scrutiny due to concerns over information disclosure and its initial trading performance, even though it exhibited minimal underpricing compared to other IPOs.5,4
Limitations and Criticisms
While often viewed positively by initial investors, IPO underpricing is not without its limitations and criticisms.
One significant criticism is the concept of "money left on the table." For the issuing company, every dollar by which the shares are underpriced below their market clearing price on the first day is capital that the company does not receive. This represents a direct cost to the firm and its existing Shareholders. Critics argue that this indicates an inefficiency in the IPO pricing mechanism, as companies could theoretically raise more funds without additional dilution.
Another point of contention revolves around the motivations of underwriters. Some critics suggest that underwriters may intentionally underprice IPOs to benefit their large institutional clients, who are often allocated the bulk of the shares. These clients then profit from the immediate price surge. This creates a potential conflict of interest for the Investment Banks, who are supposed to be acting in the best interest of the issuing company but also seek to maintain strong relationships with their buy-side institutional clients for future business.
Furthermore, while underpricing is a common occurrence, not all IPOs experience a "pop." Some IPOs may be overpriced, leading to a decline in share price on the first day or shortly thereafter, resulting in losses for initial investors. This underscores the inherent risk in IPO investing. The IPO pricing process is complex, relying on projections and market sentiment rather than established market prices, which makes precise Valuation difficult and prone to error.,
IPO Underpricing vs. IPO Overpricing
IPO underpricing and IPO overpricing are two opposing outcomes in the initial public offering process, fundamentally differing in their impact on the issuing company and initial investors.
| Feature | IPO Underpricing | IPO Overpricing |
|---|---|---|
| Definition | Offer price is below the first-day closing price. | Offer price is above the first-day closing price. |
| First-Day Return | Positive (stock price increases). | Negative (stock price decreases). |
| Benefit To | Initial investors receiving allocations. | N/A (generally benefits no one, potentially harms all). |
| Cost To | Issuing company (less capital raised). | Initial investors (immediate loss); issuing company (negative market perception). |
| Market Signal | Strong demand, successful launch, positive momentum. | Weak demand, potentially failed launch, negative sentiment. |
| Outcome for Company | "Money left on the table," but often a "successful" IPO launch. | "Busted IPO," reputational damage, investor distrust. |
While IPO underpricing is generally seen as a desirable outcome for investors and a manageable cost for the issuing company, IPO overpricing is widely considered a failure. Overpriced IPOs can severely damage a company's reputation, erode investor confidence, and make it more challenging to raise capital in the future. Investment bankers generally strive to avoid overpricing at all costs, as a failed IPO can have lasting negative implications for all involved parties.
FAQs
Why do companies underprice their IPOs?
Companies and their underwriters may underprice IPOs for several strategic reasons. One primary reason is to create a strong initial market demand, ensuring that all shares are sold and that the stock performs well on its first day of trading. This positive momentum helps build investor confidence and can be beneficial for the company's long-term Market Capitalization. Other reasons include compensating Institutional Investors for the risk of investing in a new issue (known as the "winner's curse" theory) or to mitigate potential litigation risk if the stock performs poorly after its debut.3,2
Who benefits from IPO underpricing?
The primary beneficiaries of IPO underpricing are the investors who receive allocations of shares at the initial offer price. These investors can realize immediate profits by selling their shares at the higher closing price on the first day of trading. While the issuing company "leaves money on the table," it benefits from a successful launch, positive market perception, and satisfied investors, which can facilitate future financing activities.
Is IPO underpricing always intentional?
No, IPO underpricing is not always intentional. While strategic underpricing is a common practice, accidental underpricing can also occur.1 The process of pricing an IPO is complex and involves forecasting future demand and market conditions, which is not an exact science. Even with thorough Financial Statements analysis and market expertise, underwriters may underestimate the true market appetite for a new stock, leading to a larger-than-expected price surge on the first day.
What is a "first-day pop" in an IPO?
A "first-day pop" refers to a significant increase in an IPO's stock price from its offer price to its closing price on the first day of public trading. It is a direct result of IPO underpricing and signifies strong demand for the shares in the aftermarket. For investors, a large first-day pop indicates a highly successful IPO and an immediate gain on their investment.