Investment Bank Compensation in Venture and Non-Venture Capital Backed IPOs

We address two puzzles of the IPO literature: (1) Why do investment banks earn positive profits in a competitive market? And (2) Why do banks receive lower gross spreads in 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 set in the first stage 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. Competition may take place in additional features of the IPO contract as, for example, the number of co-managers or analyst coverage. We show that in equilibrium superiorly informed VC backed issuers impose smaller spreads. JEL Classification: G14, G24.