What Determines the Level of IPO Gross Spreads? Underwriter Profits and the Cost of Going Public

This paper proposes an integrated framework to address three empirical findings of the literature on initial public offerings. (i) Why do investment banks earn positive profits in a competitive market? (ii) Why do banks receive lower gross spreads in venture capitalist (VC) backed IPOs? (iii) Why is underpricing more pronounced in VC than in non-VC backed IPOs? We model the IPO procedure as a two-stage signaling game. In the second stage banks set offer prices given their private information and the level of the spread. Issuers anticipate the bank’s pricing decision and, in the first game stage, set spreads to maximize expected revenue. Investors are aware of this process and subscribe only if their expected profits are non-negative. As a result, issuers offer high spreads to induce banks to set high prices, allowing them profits. We show that in equilibrium superiorly informed VC backed issuers impose smaller spreads but face larger underpricing than non-VC backed issuers. JEL Classification: G14, G24.