Review of Quantitative Finance and Accounting, 25: 293–312, 2005

c 2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.

Pursuing Value Through Liquidity in IPOs:

Underpricing, Share Retention, Lockup, and Trading
Volume Relationships
STEVEN X. ZHENG
Department of Accounting and Finance, Asper School of Business, University of Manitoba, Winnipeg, MB, Canada,
Tel: 204-474-7933; Fax: 204-474-7545
E-mail: zhengxs@ms.umanitoba.ca

JOSEPH P. OGDEN∗
FRANK C. JEN
Department of Finance and Managerial Economics, School of Management, University at Buffalo, SUNY, Buffalo,
NY 14260, Tel: 716-645-3270; Fax: 716-645-2131
E-mail: joeogden@buffalo.edu
E-mail: yingchi@juno.com

Abstract. We argue that in an initial public offering (IPO), pre-IPO owners make decisions regarding underpric-
ing, share retention, and share lockup simultaneously and optimally to maximize aftermarket liquidity. We predict
that underpricing fosters higher trading volume in both the short run and the long run. Also, liquidity is negatively
related to the proportion of shares retained by pre-IPO owners, ceteris paribus, so IPO underpricing should be
positively related to the proportion of shares retained, as an offset. We document evidence consistent with these
predictions. In addition, we find that, for IPOs with a lockup restriction, underpricing is more substantial and the
positive relation between share retention and underpricing is much stronger. We also find that the relationship
between underpricing and trading volume is stronger for IPOs with lockup. IPOs with lockup have higher trading
volume, and a significant portion of this difference is associated with the effect of underpricing.

Key words: IPO, underpricing, share retention, liquidity, lockup, trading volume

JEL Classification: G10, G14, G24

1. Introduction

As a firm prepares for its initial public offering (IPO) of stock, three decision variables are
prominent: (1) the extent to which the firm’s stock will be underpriced at the offering; (2)
the percent of the firm’s shares that pre-IPO owners retain after the IPO; and (3) whether to
include a lockup provision, whereby pre-IPO shareholders temporarily refrain from selling
their stock in the aftermarket. The finance literature provides several explanations for firms’
decisions regarding each of these variables. In this paper, we take the stance that an IPO
firm makes these decisions simultaneously and optimally with the goal of maximizing the
liquidity of its stock.

∗ Corresponding author.
294 ZHENG, OGDEN AND JEN

We argue that pre-IPO shareholders are pressured to retain shares due to the information
asymmetry problem. This problem, and thus share retention ratios, likely vary across IPO
firms. However, as share retention rises, liquidity is reduced because the firm will float fewer
shares, ceteris paribus. To offset the negative liquidity effect of share retention, an IPO firm
can deliberately underprice its shares at the offering, which will increase liquidity by enticing
more investors to own the stock. The cost of underpricing is the partial loss of the value of
shares that pre-IPO owners sell at the offering. However, the cost of underpricing decreases
as share retention increases. We assume that share retention is relatively more important in
terms of the ultimate goal of maximizing pre-IPO owners’ wealth. This assumption leads
to our prediction that IPO underpricing is positively related to the proportion of shares
retained. We present evidence consistent with this prediction.
We also predict that underpricing fosters higher trading volume in both the short run
and the long run. We present evidence consistent with this prediction. In addition, we
find that for IPOs with a lockup restriction (vs. IPOs with no lockup): (1) underpricing is
more substantial; and (2) the positive relation between share retention and underpricing is
much stronger. We also compare the relation between underpricing and aftermarket trading
volume for IPO firms with and without lockup. We find that the relationship between
underpricing and trading volume is stronger for IPOs with lockup. IPOs with lockup also
have higher trading volume, and a significant portion of this difference is associated with
the effect of underpricing. The evidence supports the argument that for IPOs with lockup,
underpricing improves liquidity more effectively; thus its use is more closely associated
with share retention.
The remainder of the paper is organized as follows. In Section 2 we review the literature
and develop our hypotheses. In Section 3 we discuss our dataset and present empirical
results. Section 4 concludes.

2. Literature review and hypothesis development

In this section, we review the IPO literature and discuss hypotheses about the separate
and interactive effects of underpricing, share retention, and the lockup restriction on the
aftermarket liquidity of an IPO stock.

2.1. Why focus on liquidity?

In going public, the ultimate objective of pre-IPO owners is to maximize their wealth
(Aggarwal et al., 2002; Ang and Brau, 2003). In this paper, we focus on a secondary
objective: to establish a liquid market for the firm’s stock. While wealth maximization and
aftermarket liquidity are distinct objectives, they are closely related. For instance, Ritter and
Welch (2002) argue: “Public trading. . . can, in itself, add value to the firm, as it may inspire
more faith in the firm from other investors, customers, creditors, and suppliers” (p. 1978).
In addition, liquidity reduces the cost capital for firms in general (Amihud and Mendleson,
1986; Butler, Grullon and Weston, 2005), and IPO firms in particular (Booth and Chua,
1996). Also, Demers and Lewellen (2003) find that underpricing of internet IPO stocks is
positively related to subsequent web traffic growth. For these reasons, we posit that pre-IPO
PURSUING VALUE THROUGH LIQUIDITY IN IPOS 295

owners’ decisions regarding underpricing, share retention, and lockup are important and
are likely made simultaneously and optimally to maximize the aftermarket liquidity of their
stock, which in turn serves the primary goal of wealth maximization.

2.2. IPO underpricing and liquidity

Numerous articles in the finance literature document evidence of substantial underpricing

in IPOs. (See Ibbotson, Sindelar and Ritter (1994) and Ritter and Welch (2002) for sum-
maries of the evidence.) The most common explanation for IPO underpricing focuses on the
information asymmetry problem (e.g., Rock, 1986; Allen and Faulhaber, 1989; Grinblatt
and Huang, 1989; Welch, 1989; Balvers et al., 1993; Booth and Chua, 1996; Jenkinson
and Ljungqvist, 1996; Aggarwal, Krigman and Womack, 2002; Ellul and Pagano, 2004).
Ritter and Welch (2002) summarize the asymmetric information problem in IPOs, and its
resolution via underpricing, as follows: “If the issuer is more informed than investors, ra-
tional investors fear a lemons problem: Only issuers with worse-than-average quality are
willing to sell their shares at the average price. To distinguish themselves from the pool of
low-quality issuers, high-quality issuers may attempt to signal their quality. In these models,
better quality issuers deliberately sell their shares at a lower price than the market believes
they are worth, which deters lower quality issuers from imitating.” (p. 1803)
Among the studies cited above, Booth and Chua (1996) relates most closely to our anal-
ysis. They argue that IPOs must be underpriced to induce potential investors and others to
produce information on the issuer. Specifically, underpricing is likely to lead to oversub-
scription to the offering, which in turn tends to result in broad initial ownership, which in
turn increases aftermarket liquidity. Broad initial ownership, however, requires an increase
in investor-borne information costs. Underpricing compensates investors for these costs.
Thus, IPO underpricing improves liquidity by fostering greater ownership dispersion.
Empirically, Booth and Chua find a positive relationship between underpricing and own-
ership dispersion. Kligman et al. (1999) examine the relationship between underpricing and
short-term (i.e., through the first five post-IPO trading days) trading volume for 611 IPOs
issued from 1993–1995. They document a positive relationship. We examine the relation-
ships between underpricing and both short- and longer-term post-IPO trading volume using
thousands of IPOs issued over the years 1976–1998. We document evidence of a positive
relationship at both volume horizons. In addition, we find that the relationship is influenced
by the both the level of share retention and the presence of a lockup provision.

2.3. Share retention and liquidity

As noted above, IPO underpricing is well recognized as a mechanism to alleviate the infor-
mation asymmetry problem. Surprisingly, the IPO literature has not focused substantially
on an alternative signal, share retention, despite Leland and Pyle’s (1976) widely-cited
theoretical argument that an entrepreneur’s willingness to invest in his own project (i.e., to
retain shares) is a powerful signal of value.
However, as pre-IPO owners retain more shares, fewer shares are floating in the aftermar-
ket, ceteris paribus. With fewer floating shares, IPO stocks will have lower trading volume
296 ZHENG, OGDEN AND JEN

and thus lower liquidity. In addition, when more shares are retained, outside investors are
more likely to trade with pre-IPO owners (i.e., after trading restrictions expire, and notwith-
standing the prohibition on insider trading), who generally have inside information about
the firm. As such, outside investors face greater moral hazard risk in trading, which further
reduces their trading interest. These arguments lead to the prediction of a negative rela-
tionship between share retention and trading volume. However, this relationship may be
affected by the underpricing and lockup decisions, as we discuss below.

2.4. Tradeoffs: Underpricing, share retention, and liquidity

Both underpricing and share retention impart benefits for, and costs to, pre-IPO shareholders.
In brief, both underpricing and share retention benefit pre-IPO owners as signals of value.
However, underpricing is costly in terms of direct wealth loss, while share retention is costly
because pre-IPO shareholders must maintain substantial positions in the firm’s stock (i.e.,
they cannot achieve the benefits of diversification on personal account). Moreover, while
underpricing improves liquidity, share retention reduces liquidity.
The tradeoff between underpricing and share retention is three-fold. First, as more shares
are retained, pre-IPO owners lose less initially, and potentially gain more later, from under-
pricing. The more shares pre-IPO owners retain, the more shares they can sell later in the
aftermarket. If the stock is liquid, investors will demand a lower liquidity premium on the
stock, and thus the market price will be higher. In addition, higher liquidity means lower
trading cost (e.g., bid-ask spread), which further improves the (net) price that pre-IPO own-
ers receive when they later sell retained shares. Thus, pre-IPO owners have more incentive
to improve the liquidity of the stock by underpricing when they retain more shares. On the
other hand, if pre-IPO owners do not retain any shares, they care less about liquidity in the
aftermarket, but are highly concerned about the offer price, so they have no incentive to
underprice the offering.
Second, when more shares are retained, the number of floating shares will be reduced
and the stock will be less liquid, ceteris paribus. Thus, underpricing is required to improve
liquidity.
Third, the more shares pre-IPO owners retain, the less costly underpricing is to them. For
example, for a given level of underpricing, if pre-IPO owners offer only 10% of the original
shares to the market and retain 90%, the underpricing will cost them only 1% of the value
of their shareholdings.1 On the other hand, if they offer 90% of their shareholdings in IPO,
the underpricing will lead to a possible 9% loss in their wealth.2 Obviously, higher share
retention will make underpricing less costly.
The first argument above provides an incentive for pre-IPO owners to underprice the IPO
when they retain a significant number of shares. The second and the third effect strengthen
the first effect. Overall, as pre-IPO owners retain more shares, they will underprice the IPO
more substantially. Thus, these arguments suggest following testable hypotheses:

(1) Share retention is positively related to IPO underpricing.

(2) When pre-IPO owners retain few shares, the IPO will not be underpriced.
PURSUING VALUE THROUGH LIQUIDITY IN IPOS 297

Bradley and Jordan (2002) document evidence consistent with hypothesis (1) above (see
their Figure 2, p. 604). Loughran and Ritter (2004) also document evidence consistent with
hypothesis (1) above (see their Tables II, V, and VI). We document evidence consistent with
both hypotheses.

2.5. The effect of lockup

Many IPO contracts include a lockup restriction, which prohibits pre-IPO owners from
selling retained shares for a certain period. The standard lockup period is 180 days. It is
difficult to determine the net effect of lockup on liquidity. On one hand, lockup prevents
the trading of retained shares, reducing the number of floating shares and thus reducing
liquidity. On the other hand, lockup prevents insiders from taking advantage of outside
investors in stock trading during the lockup period, which would otherwise reduce trading
volume. In addition, if there is less insider-based information content in the aftermarket
trading of an IPO stock with lockup, the stock’s bid-ask spread will be lower. Both of
the latter effects encourage trading. It is difficult to determine whether they outweigh the
negative effect of lockup on trading volume. We must rely on empirical data to determine
the net effect of lockup on trading volume.
It is also difficult to determine the effect of lockup on the relation between IPO under-
pricing and share retention. However, we suspect that, if underpricing can improve liquidity
more significantly for IPOs with lockup, pre-IPO owners will be more willing to underprice
the IPO for the same magnitude of share retention, and the relation between share retention
and underpricing will be more substantial. Our argument is based in part on Aggarwal et al.
(2002), who present a model in which the issuers strategically underprice the IPO in order
to maximize their wealth from selling shares at lockup expiration. They argue that first
day underpricing creates information momentum, i.e., it generates incremental comments
and recommendations by research analysts, especially by non-lead underwriter analysts.
Assuming a downward sloping demand curve, they suggest that this increased research
coverage shifts the demand curve for the stock outward, allowing pre-IPO owners to sell
shares at the lockup expiration at prices higher than they would otherwise be able to obtain.
(See also Brav and Gompers (2003).)

3. Data and empirical results

3.1. Sample characteristics and preliminary evidence

Our preliminary sample consists of IPOs of U.S. firms collected from Security Data Com-
pany’s (SDC) new-issues database. We identify a total of 6,421 IPOs issued between January
1976 and December 1998. We chose year-end 1998 as our ending date in order to avoid
dealing with the ‘bubble’ period of 1999–2000 (see Loughran and Ritter, 2004). We then
delete observations with either missing data or where SDC data conflicts with correspond-
ing data in the Center for Security Prices (CRSP) database. The final sample consists of
5,183 IPOs. Included among the variables that we collected for these IPOs is daily post-
IPO volume data, obtained from the CRSP daily file. The volume reporting conventions for
298 ZHENG, OGDEN AND JEN

Nasdaq are such that we halved the reported volumes for Nasdaq stocks. We also note that,
due to missing data, we have slightly smaller numbers of observations for tests involving
trading volume data. In addition, trading volume data is not available for Nasdaq stocks
prior to November 1982; consequently, our volume data for IPOs prior to this date consists
of only NYSE and AMEX IPOs.
The yearly distributions of the IPOs in the original sample and the final sample are
reported in Table 1. Comparing the preliminary sample to the final sample, we find that our
sample selection criteria resulted in the discarding of most IPOs before 1980. For the other
years, our final sample compares closely to the preliminary sample. The distributions in the
table indicate that the number of offerings fluctuates substantially over time. For example,
our final sample contains 534 IPOs in 1996 but only 66 IPO in 1982. Apparently the lockup
restriction was initiated in 1988, as no IPOs prior to that year include a lockup. In that

Table 1. The IPO sample: Yearly distributions and totals

Initial sample Final sample

Year Not locked Locked All Not locked Locked All

1976 35 0 35 4 0 4
1977 25 0 25 1 0 1
1978 34 0 34 0 0 0
1979 57 0 57 4 0 4
1980 118 0 118 21 0 21
1981 279 0 279 178 0 178
1982 96 0 96 66 0 66
1983 559 0 559 461 0 461
1984 246 0 246 196 0 196
1985 279 0 279 228 0 228
1986 550 0 550 431 0 431
1987 389 0 389 303 0 303
1974–1987 2,667 0 2,667 1,893 0 1,893
1988 86 110 196 66 90 156
1989 51 96 147 42 89 131
1990 53 80 133 41 70 111
1991 52 213 265 41 195 236
1992 86 314 400 72 294 366
1993 138 428 566 120 406 526
1994 57 342 399 48 320 368
1995 31 360 391 26 339 365
1996 40 566 606 26 508 534
1997 31 379 410 27 312 339
1998 24 217 241 8 150 158
1988–1998 649 3,105 3,754 517 2,773 3,290
Total 3,316 3,105 6,421 2,410 2,773 5,183

The initial sample is collected from the SDC database. The final sample is obtained after deleting
observations with either missing data or where SDC data conflicts with corresponding data in the
CRSP database.
PURSUING VALUE THROUGH LIQUIDITY IN IPOS 299

year, more than half of the IPOs are locked. Since then, the vast majority of IPOs include
a lockup restriction. In 1998, only 8 of the 158 IPOs in the final sample do not include a
lockup restriction.
Table 2 reports mean statistics for several sample variables, both for the full final sample
and for three sub-samples. The first sub-sample includes IPOs issued before 1988, the year
in which the lockup restriction first appears. The second and third sub-samples include
IPOs after 1988 without and with the lockup restriction, respectively. Following Downs and
Heinkel (1982), we define the retention ratio as the ratio of the number of shares retained
by pre-IPO shareholders to total shares outstanding after the IPO. This ratio is denoted as
Retention1.

Table 2. Mean values of variables and t-tests

IPOs after 1988

IPOs before Not t-stat. for

All 1988 locked Locked difference

Offer price ($) 10.98 10.47 12.10 11.11 2.47

1st day market price ($) 12.20 11.27 12.29 12.78 −2.13
Shares offered (Millions) 3.43 2.32 9.99 2.94 8.97
Shares retained (Million) 5.31 4.08 2.20 6.70 9.44
Retention 1 0.58 0.62 0.26 0.63 −24.82
Proportion backed by VC 0.32 0.25 0.08 0.40 −21.39
Proportion listed in Nasdaq 0.75 0.74 0.38 0.83 −20.35
Secondary 0.12 0.15 0.03 0.11 −11.85
Percentage with nonzero UP1 7.53 0.00 5.80 12.74 −5.73
Nonzero UP1 (%) 19.05 10.00 19.64 19.03 0.12
Percentage with nonzero DW1 10.20 0.00 6.77 17.51 −8.12
Nonzero DW1 (%) −17.59 − −13.52 17.89 2.89
Percentage with nonzero UP2 29.53 24.36 13.15 35.96 −13.05
Nonzero UP2 (%) 11.08 10.36 10.04 11.47 −1.52
Percentage with nonzero DW2 37.36 31.08 11.41 35.52 −14.42
Underwriter market share (%) 3.74 3.17 8.04 3.31 10.80
Nonzero DW2 (%) −13.49 −14.71 −11.38 −12.55 0.88
Overallot 0.15 0.15 0.14 0.15 −1.62
LAG 11.93 9.36 11.09 13.78 −8.79
RUNUP 1.50 0.90 1.97 1.81 1.14
Initial return (IR) (%) 11.44 8.87 5.89 14.22 −10.61

Shares retained is the difference between shares outstanding after the IPO and shares offered. Secondary is the
proportion of secondary shares among all the shares offered in IPO. Overallot is the proportion of over-allotment
shares relative to shares offered. Underwriter market share is the percentage average equity IPO market share of
the lead underwriter by year. Retention1 is (shares retained)/(shares outstanding after IPO). LAG is the average
percentage initial return for all IPOs on calendar days −1 to −30 before the issue date. RUNUP is the cumulative
percent return on the CRSP equally weighted index for fifteen trading days before the issue. UP1 (DW1) is the
percentage difference between the original mid-file price relative the amended mid-file price for firms that amend
their original file range up (down), zero otherwise. UP2(DW2) is the percentage difference between the final
mid-file price relative to the final offer price for those companies that had offer prices above (below) the final mid
file price, zero otherwise. Initial return is the difference between offer price and 1st day closing price, divided by
offer price.
300 ZHENG, OGDEN AND JEN

Comparing mean statistics across the three sub-samples, we note the following important
differences:

(1) Unlocked IPOs after 1988 generally involve more shares, 9.99 million shares on average,
compared to 2.32 million and 2.94 million for unlocked IPOs before 1988 and locked
IPOs after 1988, respectively.
(2) On average, pre-IPO owners retain a smaller proportion of the shares of unlocked post-
1988 IPOs than for the other two sub-samples (26% compared to 62% and 63% for
unlocked IPOs before 1988 and locked IPOs after 1988, respectively). Indeed, for more
than half of the post-1988 unlocked IPOs, pre-IPO owners do not retain any shares.
(3) On average, a smaller proportion of the post-1988 unlocked IPOs were backed by a
venture capital firm (VC) (8%, compared to 25% and 40% for unlocked IPOs before
1988 and locked IPOs after 1988, respectively).
(4) On average, a smaller proportion of post-1988 unlocked IPOs were listed on NASDAQ
(as opposed to NYSE/AMEX) (38%, compared to 74% and 83% for unlocked IPOs
before 1988 and locked IPOs after 1988, respectively).
(5) On average, the proportion of secondary shares to total shares offered was smaller for
post-1988 unlocked IPOs (3%, compared to 15.4% and 11% for unlocked IPOs before
1988 and locked IPOs after 1988, respectively).
(6) On average, a smaller proportion of post-1988 unlocked IPOs incurred either an upward
revision or downward revision in their offering price prior to the IPO.
(7) Post-1988 unlocked IPOs are more likely to have been underwritten by a larger, more
prestigious investment bank.
(8) Finally, post-1988 IPOs with lockup have a higher average initial return (14.22%) than
either pre-1988 IPOs (8.87%) or unlocked post-1988 IPOs (5.89%). Thus, locked IPOs
are more substantially underpriced, on average.

Regarding point (8) above, in the next section we test whether underpricing is related to the
lockup restriction per se, or is driven by other, correlated factors.

3.2. Testing the relation between share retention and underpricing

3.2.1. The general pattern. To test hypotheses (1) and (2) discussed in Section 2.4, we
examine the relationship between share retention and IPO underpricing. We sort IPOs into
six groups according to the level of Retention1 (proportion of shares retained), and then
compare average underpricing across these groups. Retention1 is not distributed uniformly
across the range of zero and one, so to determine breakpoints we imposed the restriction
that each group has more than 500 observations in the full sample. As a result, the first
group contains IPOs with Retention1 under 0.01. The second group includes IPOs with
Retention1 between 0.01 and 0.5. IPOs with Retention1 between 0.5 and 0.6 are assigned
to group 3. IPOs in the fourth group are those with Retention1 between 0.6 and 0.7. IPOs in
the fifth group are those with Retention1 between 0.7 and 0.8. Finally, IPOs with Retention1
above 0.8 are assigned to group 6.
PURSUING VALUE THROUGH LIQUIDITY IN IPOS 301

Figure 1. Underpricing for all IPOs in the sample, grouped by retention level.

Figure 1 shows the mean and median underpricing for IPOs in each Retention1 group.
Mean underpricing is nearly monotonically increasing in share retention. When pre-IPO
owners retain less than 1% of the shares, the IPOs are underpriced by 1.82% on average
(0.0% in the median). This is consistent with our hypothesis that IPOs will not be substan-
tially underpriced when pre-IPO owners retain few shares. As share retention increases,
mean underpricing also increases. When pre-IPO owners retain more than 80% of all the
shares, the IPOs are underpriced by nearly (a median of) 16%, consistent with our hy-
pothesis that underpricing is positively related to share retention. However, as shown the
relationship is noticeably weaker based on mean statistics.
Of course, other factors also affect underpricing, and must be controlled in order to more
accurately gauge the net effect of share retention on underpricing. Next, we use multivariate
regression analysis to test the relation between share retention and IPO underpricing.
The multivariate regression model is as follows:

IRi = b0 + b1 Retention1 + X i B + u i , (1)

where IR is the first-day or initial return on IPO stock i, calculated as the percentage
difference of the first-day closing price to the offer price, Retention1 is as previously defined,
and X is a vector of control variables. The coefficient b1 will be positive if the relationship
documented in Figure 1 is robust to controls for other factors.
We select control variables based on the existing literature on IPO underpricing. Hanley
(1993) and Loughran and Ritter (2002) find that IPOs with upward price revision are
underpriced more severely. Following Bradley and Jordan (2002), we use four variables
to measure offer price revision. UP1 (DW1) is equal to the percentage difference between
the original mid-file price relative to the amended mid-file price for firms that amend their
original filed price range up (down), and is zero otherwise. UP2 (DW2) is equal to the
302 ZHENG, OGDEN AND JEN

percentage difference between the final mid file price relative to the final offer price for
those companies that had final offer prices above (below) the final mid file price, and is zero
otherwise.
Also following Bradley and Jordan, we use LAG, defined as the average percentage initial
return on all IPOs on calendar days −1 to −30 before the issue date. We include this variable
to control for possible time series autocorrelation of IPO initial returns (i.e., the ‘hot’ versus
‘cold’ IPO market phenomenon (Loughran and Ritter, 2000; Lowry and Schwert, 2001)).
Hanley (1993) finds that IPO underpricing is positively related to the market return before
IPO. To control for this factor, we use RUNUP, the cumulative percentage return of CRSP
equally weighted index in the fifteen trading days leading up to the issue date.
We also control for the influence of insider selling as reported in Habib and Ljungqvist
(2001). Our control variable for this factor is SECON, the proportion of secondary shares
among all shares offered.
Previous researchers (Beatty and Ritter (1986), Carter and Manaster (1990), etc.) find
that IPO underpricing is related to the market share of the lead underwriter, the size of the
offering, and the offer price. To control for the effects of these characteristics, we include
the following three variables: (a) UWMS, the percentage average equity IPO market share
of the lead underwriter by year; (b) LISIZE, the natural log of number of shares offered;
and (c) INVP, the inverse of offer price.
The relationships between IPO underpricing and other characteristics either have not been
explored or are unclear, so we include additional variables to control for these characteristics.
These variables are ALLOT, VENTURE, NASDAQ and LOCK. ALLOT is the proportion
of over-allotment shares relative to shares offered. VENTURE is a dummy equal to one
when the IPO firm is backed by a VC, and zero otherwise. NASDAQ is a dummy equal to
one when the IPO is issued in Nasdaq, and zero otherwise. LOCK is a dummy equal to one
when the IPO has lockup provision, and zero otherwise. The regressions also include 13
industry dummies to control for any possible industry effects.
The regression results for the entire sample are reported in the first two columns of
Table 3. The coefficient on Retention1 is positive and highly significant. Thus, the posi-
tive relationship between share retention and underpricing is robust to controls for other
factors, and is consistent with the results of the grouping analysis shown in Figure 1.
The hypothesis that IPO underpricing is positively related to share retention is strongly
supported.
The coefficients of UP1, UP2, DW2, LAG, INVP, RUNUP are all positive and highly
significant, and that of SECON is negative and significant. The coefficient for VENTURE
is negative and significant, suggesting that IPOs backed by VCs are less underpriced. These
results are consistent with previous studies including Bradley and Jordan (2002). The co-
efficient of NASDAQ is positive and significant, indicating that NASDAQ IPOs are more
underpriced.

3.2.2. The influence of lockup. The coefficient of the final independent variable shown
in Table 3, LOCK, is positive and significant, with a value of 1.41 (t-value of 2.37). This
suggests that locked IPOs are slightly more underpriced, even after controlling for many
factors, including share retention.
PURSUING VALUE THROUGH LIQUIDITY IN IPOS 303

Table 3. Regression results: Dependent variable is initial return

IPOs without lockup

All IPOs IPOs before 1988 after 1988 IPOs with lockup

Coefficient t-stat. Coefficient t-stat. Coefficient t-stat. Coefficient t-stat.

Intercept 14.19 2.40 18.01 2.32 −5.73 −0.59 22.71 1.96

Retention1 7.73 5.59 2.24 1.14 6.98 2.30 1.10 4.62
UP1 0.41 10.94 −1.29 −0.89 −0.01 −0.14 0.45 9.57
DW1 0.08 1.92 0.21 1.56 0.05 1.02
UP2 0.76 18.74 0.50 7.63 0.77 5.82 0.81 14.50
DW2 0.35 11.23 0.27 7.45 0.11 0.90 0.44 8.16
LAG 0.19 6.04 0.31 5.77 0.21 2.15 0.17 3.85
UWMS −0.01 −0.27 −0.30 −3.30 −0.06 −0.97 0.15 1.84
LISIZE −0.85 −2.21 −0.75 −1.47 0.69 1.20 −1.54 −2.06
INVP 3.66 9.85 3.00 8.53 6.89 7.18 4.92 4.75
RUNUP 0.49 5.87 0.42 4.06 0.14 0.81 0.62 4.43
ALLOT −0.05 −0.03 4.81 2.22 −7.68 −1.07 −2.62 0.93
SECON −6.85 5.14 −7.69 −4.92 −9.43 −2.09 −4.58 −2.00
VENTURE −2.46 −4.01 −2.11 −2.50 −1.43 −0.63 −2.72 −3.02
NASDAQ 2.21 3.16 0.08 0.09 5.34 2.79 3.23 2.66
LOCK 1.41 2.37
No. obs. 5,183 1,893 517 2,773
Adj. R 2 0.246 0.223 0.402 0.237

The dependent variable is initial return (IR), measured as the difference between first trading day closing price and
offer price, divided by offer price. Retention1 is measured as (share retained)/(shares outstanding after IPO). UP1
(DW1) is equal to the precentage difference between the original mid file price relative the amended mid file price
for firms that amend their original file range up (down), zero otherwise. UP2(DW2) is equal to the percentage
difference between the final mid file price relative to the final offer price for those companies that had final offer
prices above (below) the final mid file price, zero otherwise. LAG is defined as the average percentage initial
return for all IPOs on calendar days −1 to −30 before the issue date. UWMS is the percentage average equity IPO
market share of the lead underwriter by year. LISIZE is the log of number of shares offered. INVP is the inverse
of offer price. RUNUP is the cumulative percentage return of CRSP equally weighted index fifteen trading days
before the issue.
ALLOT is the proportion of over-allotment shares relative to shares offered. SECON is the proportion of
secondary shares among all the shares offered. VENTURE is a dummy which is equal to one when the IPO firm
is backed by venture capital, zero otherwise. NASDAQ is a dummy which is equal to one when the IPO is issued
in Nasdaq, zero otherwise. LOCK is a dummy which is equal to one when the IPO has lockup provision. The
regressions also include 13 industry dummies not reported in this table.

However, this initial multivariate regression provides only a rough test of the influence
of lockup on underpricing. As a finer test, we repeat the multivariate regression using
separate data for each of the previously-defined three groups of IPOs: IPOs before 1988,
IPOs without lockup after 1988, and IPOs with lockup. The results are displayed in the
remaining columns of Table 3.
For IPOs without lockup before 1988, the coefficient for Retention1 is insignificant (2.24;
t-value of 1.14). For post-1988 IPOs with lockup, the coefficient for Retention1 is positive
304 ZHENG, OGDEN AND JEN

and highly significant (10.10; t-value of 4.62). The coefficient of Retention1 is also positive
and significant for post-1988 IPOs without lockup; however, the size and significance levels
(6.98; t-value of 2.30) are much lower than for the post-1988 locked IPOs. These results
indicate that the positive relationship between share retention and IPO underpricing is much
stronger for IPOs with lockup.
Additional perspectives on the influence of lockup on underpricing are provided in
Figures 2–4. These figures show average initial returns for each of the three sub-samples
of IPOs by the previously-defined ranges of Retention1. The patterns are very different

Figure 2. Underpricing for IPOs before 1988, grouped by retention level.

Figure 3. Underpricing for IPOs without lockup after 1988, grouped by retention level.
PURSUING VALUE THROUGH LIQUIDITY IN IPOS 305

Figure 4. Underpricing for IPOs with lockup after 1988, grouped by retention level.

across the three sub-samples. For IPOs before 1988, an inverse U shape is apparent in un-
derpricing as a function of retention. For post-1988 IPOs without lockup, underpricing first
increases with share retention, but then stabilizes as retention increases further. In contrast,
for post-1988 IPOs with lockup, underpricing monotonically and substantially increases
with share retention. This evidence further indicates that the positive relationship between
share retention and underpricing is much stronger for IPOs with lockup.

3.3. Testing the relation between underpricing and liquidity

3.3.1. The time series behavior of trading volume. According to our main hypothesis,
pre-IPO owners underprice their IPO to improve the liquidity of the stock in the aftermarket.
Our hypothesis draws support from the empirical results of Reese (2003), who provides
evidence that aftermarket trading volume is positively related to IPO underpricing. Reese
(2003) examines the aftermarket weekly trading volume of IPO stocks. We contend that it
is better to use daily trading volume because the number of trading days may be different
in different weeks. However, daily trading volume can be very volatile, so we use the time
series averages of daily trading volume. To determine the range of the time series, we
initially investigate trading volume behavior for IPO stocks over the 500 trading days after
the IPO date.
For each stock and each of the 500 trading days after the IPO date, we multiply trading
volume by 1000 and then divide it by shares outstanding to obtain an adjusted daily trading
volume for the stock. Then we calculate the cross sectional average of the adjusted daily
trading volume for each of the 500 trading days after the IPO date. Figure 5 displays
time series values of these cross sectional averages of adjusted daily trading volume. In
Figure 5, arvol is the cross sectional average adjusted trading volume for the IPOs in the
full sample. Adjusted trading volume is highest during the first few days after the IPO date,
306 ZHENG, OGDEN AND JEN

Figure 5. Cross-sectional averages of post-IPO adjusted daily trading volume. From (generally) highest to lowest
are trading volumes for locked IPOs (arvollk), all IPOs (arvol), non-locked IPOs after 1988 (arvoll2), and non-
locked IPOs before 1988 (arvoll1).

then decreases during the first 80 trading days and reaches an asymptote. After an additional
40 days or so of flat trading volume, the adjusted volume jumps at the expiration of lockup.
Thereafter, volume increases slowly. Around the 358th trading day (i.e., approximately 18
months after the IPO date), trading volume increases again, possibly because of another
round of lockup expirations. Volume then drops and than flattens.
We also examine the behavior of average adjusted trading volume separately for each of
the previously-defined sub-samples of IPOs. The corresponding series are also shown in
Figure 5. As expected, trading volume jumps are much stronger for IPOs with lockup. For
IPOs before 1988, the volume jumps are much smaller. For post-1988 IPOs without lockup,
volatility is greater in part because there are fewer firms in this group. Most importantly,
we observe that IPOs with lockup have higher average adjusted trading volume than IPOs
without lockup. We provide additional discussion of this difference evidence later.

3.3.2. The general pattern. We are interested in determining whether a relationship exists
between underpricing and aftermarket trading volume for IPO stocks, so we examine time
series averages of adjusted daily trading volume for two periods: from the 5th trading day
through trading day 122 and from the 129th trading day to trading day 500. For each IPO
stock (i.e., those that survive to be included), we calculate time series averages of adjusted
daily trading volume over each of the two periods. Then we examine the relation between
the averages of adjusted daily trading volume and IPO underpricing using regression (2).

VOi = h 0 + h 1 LIRi + h 2 Retention1i + X i H + u i (2)

PURSUING VALUE THROUGH LIQUIDITY IN IPOS 307

VO is the time series average of adjusted daily trading volume; LIR is the log of initial
return; h 1 , h 2 and H are coefficients; and X is the vector of control variables as defined
earlier. According to our earlier argument that underpricing enhances liquidity, we expect
h 1 to be positive.
The results of regression (2) for the full sample are reported in the first two columns
of Tables 4 and 5. For both trading periods examined, average adjusted trading volume

Table 4. Regression results: Dependent variable is average adjusted trading volume, day 5 to day 122

IPOs without lockup

All IPOs IPOs before 1988 after 1988 IPOs with lockup

Coefficient t-stat. Coefficient t-stat. Coefficient t-stat. Coefficient t-stat.

Intercept 3.62 2.32 8.92 5.57 10.19 3.03 1.74 0.58

LIR 7.25 13.89 3.67 5.87 4.62 3.14 8.78 11.42
Retention1 −3.90 −10.74 −4.43 −11.07 −3.66 −3.51 −4.65 −8.18
UP1 0.05 5.24 −0.15 −0.54 0.04 1.97 0.03 2.50
DW1 0.00 −0.41 0.04 0.84 −0.01 −0.49
UP2 0.02 1.87 0.02 1.71 0.11 2.44 0.00 0.31
DW2 −0.01 −0.85 0.00 0.17 −0.03 −0.79 0.00 0.20
LAG 0.08 9.53 −0.02 −1.62 −0.04 −1.11 0.12 10.11
UWMS −0.02 −1.23 0.06 3.34 −0.03 −1.58 0.01 0.32
LISIZE −0.03 −0.26 −0.26 −2.45 −0.24 −1.20 0.20 1.05
INVP −0.17 −1.81 −0.01 −0.12 −0.46 −1.36 −0.34 −1.26
RUNUP −3.27 −1.49 6.06 2.81 −1.30 −0.22 −5.84 −1.62
ALLOT 1.25 2.74 1.28 3.02 2.23 0.91 0.22 0.30
SECON 0.81 2.27 0.10 0.30 4.16 2.64 1.27 2.16
VENTURE 0.08 0.51 0.12 0.65 −1.51 −1.94 0.16 0.71
NASDAQ 2.09 11.25 0.82 4.85 3.69 5.53 2.30 7.33
LOCK 1.73 11.04
No. obs. 4,979 1,688 517 2,774
Adj. R 2 0.206 0.151 0.407 0.180

The dependent variable is the time series average of Adjusted Daily Trading Volume from Day 5 to Day 122 for
each IPO firm. Adjusted Daily Trading Volume is measured as daily trading volume divided by shares outstanding
on the same day. LIR is the log of initial return. Initial return is measured as the difference between first trading
day closing price and offer price, divided by offer price. Retention1 is measured as (shares retained)/(shares
outstanding after IPO). UP1 (DW1) is equal to the percentage difference between the original mid file price
relative the amended mid file price for firms that amend their original file range up (down), zero otherwise.
UP2(DW2) is equal to the percentage difference between the final mid file price relative to the final offer price
for those companies that had final offer prices above (below) the final mid file price, zero otherwise. LAG is
defined as the average percentage initial return for all IPOs on calendar days −1 to −30 before the issue date.
UWMS is the percentage average equity IPO market share of the lead underwriter by year.
LISIZE is the log of number of shares offered. INVP is the inverse of offer price. RUNUP is the cumulative
percentage return of CRSP equally weighted index fifteen trading days before the issue. ALLOT is the proportion
of over-allotment shares relative to shares offered. SECON is the proportion of secondary shares among all the
shares offered. VENTURE is a dummy which is equal to one when the IPO firm is backed by venture capital,
zero otherwise. NASDAQ is a dummy which is equal to one when the IPO is issued in Nasdaq, zero otherwise.
LOCK is a dummy which is equal to one when the IPO has lockup provision. The regressions also include 13
industry dummies not reported in this table.
308 ZHENG, OGDEN AND JEN

Table 5. Regression results. Dependent variable is average adjusted trading volume, day 129 to day 500

IPOs without lockup

All IPOs IPOs before 1988 after 1988 IPOs with lockup

Coefficient t-stat. Coefficient t-stat. Coefficient t-stat. Coefficient t-stat.

Intercept −8.32 −5.22 1.75 1.34 4.55 1.58 −16.29 −4.86

LIR 5.38 10.04 3.21 6.37 3.12 2.47 6.30 7.31
Retention1 −0.73 −1.95 −2.57 −7.78 −1.11 −1.25 0.12 −0.19
UP1 0.06 5.86 −0.12 −0.51 0.04 2.07 0.04 2.82
DW1 −0.01 −1.18 −0.06 −1.59 −0.01 −0.54
UP2 0.04 3.63 0.03 3.01 0.05 1.39 0.03 1.66
DW2 0.00 0.31 0.00 −0.75 0.03 0.72 0.02 1.30
LAG 0.00 0.28 −0.05 −5.16 −0.01 −1.18 0.02 1.25
UWMS 0.00 0.10 0.06 3.83 −0.03 −1.51 0.01 0.37
LISIZE −0.67 6.47 0.15 1.70 0.03 0.18 1.25 5.76
INVP −0.33 −3.31 −0.13 −2.11 −0.48 −1.69 −0.61 −2.01
RUNUP −0.08 −3.52 0.03 0.02 −0.06 −0.01 −0.14 −3.46
ALLOT 0.61 1.29 0.42 1.15 2.23 1.06 0.28 0.34
SECON 0.35 0.98 0.36 1.37 3.26 2.41 0.17 0.26
VENTURE 1.62 9.80 1.08 7.63 0.10 0.15 2.07 7.95
NASDAQ 1.70 9.02 0.50 3.61 1.04 1.82 2.47 7.02
LOCK 2.05 12.69
No. obs. 5,183 1,893 517 2,773
Adj. R 2 0.227 0.125 0.319 0.183

The dependent variable is the time series average of Adjusted Daily Trading Volume from Day 5 to Day 122 for
each IPO firm. Adjusted Daily Trading Volume is measured as daily trading volume divided by shares outstanding
on the same day. LIR is the log of initial return. Initial return is measured as the difference between first trading
day closing price and offer price, divided by offer price. Retention1 is measured as (shares retained)/(shares
outstanding after IPO). UP1 (DW1) is equal to the percentage difference between the original mid file price
relative the amended mid file price for firms that amend their original file range up (down), zero otherwise.
UP2(DW2) is equal to the percentage difference between the final mid file price relative to the final offer price for
those companies that had final offer prices above (below) the final mid file price, zero otherwise. LAG is defined
as the average percentage initial return for all IPOs on calendar days −1 to −30 before the issue date. UWMS is
the percentage average equity IPO market share of the lead underwriter by year.
LISIZE is the log of number of shares offered. INVP is the inverse of offer price. RUNUP is the cumulative
percentage return of CRSP equally weighted index fifteen trading days before the issue. ALLOT is the proportion
of over-allotment shares relative to shares offered. SECON is the proportion of secondary shares among all the
shares offered. VENTURE is a dummy which is equal to one when the IPO firm is backed by venture capital,
zero otherwise. NASDAQ is a dummy which is equal to one when the IPO is issued in Nasdaq, zero otherwise.
LOCK is a dummy which is equal to one when the IPO has lockup provision. The regressions also include 13
industry dummies not reported in this table.

is significantly positively related to LIR. This supports our argument that pre-IPO owners
underprice the issue to improve aftermarket liquidity.
Note that the coefficients for the dummy variable LOCK in the full-sample regressions are
positive and highly significant. These results indicate that IPOs with lockup are more actively
traded, and thus the result is consistent with the results shown in Figure 2. Considering earlier
discussions about the effect of lockup on liquidity, the evidence supports the argument that
PURSUING VALUE THROUGH LIQUIDITY IN IPOS 309

lockup prevents insiders from taking advantage of outside investors in trading, and that this
positive effect on liquidity outweighs the negative effect of lockup on the number of floating
shares. Next, we explore the relationships among lockup, underpricing, and trading volume
more closely.

3.3.3. IPOs with and without lockup. Our finding that IPOs with lockup are more actively
traded reminds us that in Section 3.2, we found higher underpricing and stronger relation
between underpricing and share retention for IPOs with lockup. Thus, the observed higher
liquidity for locked IPOs may merely be due to higher underpricing for locked IPOs. But
why are IPOs with lockup more underpriced? Possibly, lockup provides pre-IPO owners an
incentive to take actions that increase long run liquidity. Lockup may also encourage outside
investors to trade more actively. If underpricing improves long run liquidity more signifi-
cantly for IPOs with lockup, then pre-IPO owners will be more likely to use underpricing
to improve long run liquidity. If underpricing does not improve liquidity more significantly
for IPOs with lockup, pre-IPO owners will be more willing to use other methods, such as
promotion, to improve liquidity. So, the stronger relationship between underpricing and
share retention for IPOs with lockup may be associated with a stronger relation between
underpricing and aftermarket trading volume. Thus we have two hypotheses to test:

(3) The relation between underpricing and aftermarket trading volume is stronger for IPOs
with lockup; and
(4) At least part of the higher trading volume for IPOs with lockup is related to greater
underpricing.

We apply regression (2) (excluding the control variable LOCK) on the three previously-
defined IPO sub-samples. The results are reported in the remaining columns of Tables 4
and 5. Consistent with hypothesis (3) above, the coefficient on LIR is larger and much more
significant for IPOs with lockup for both trading periods examined. It appears that investors
will trade IPO shares more actively given the same degree of underpricing if the IPO has
lockup provision. Thus, pre-IPO owners will be more likely to use underpricing to improve
liquidity when the IPO is locked. This leads to the stronger relation between share retention
and IPO underpricing for IPOs with lockup that we reported earlier.
To examine hypothesis (4), we attempt to measure the net effect of underpricing on
liquidity. We do this by calculating the product of the mean of LIR and the coefficient of
LIR in the regression. The mean of LIR is the cross-sectional average of LIR. The product
can be interpreted as incremental adjusted volume associated with underpricing. Then we
compare this product to mean adjusted volume, which is the cross-sectional average of the
time series averages of VO. The results are reported in Table 6.
Clearly, underpricing is more substantially positively associated with higher trading vol-
ume for IPOs with lockup. For IPOs with lockup, the adjusted trading volume associated
with underpricing for the two trading periods are 1.04 and 0.75 respectively, much higher
than the values of 0.15 to 0.27, respectively, for IPOs without lockup. Overall, the results
suggest that underpricing explains a significant proportion of the trading volume difference
between IPOs with and without lockup.
310 ZHENG, OGDEN AND JEN

Table 6. Summary evidence on the effect of log initial return on trading volume

Mean of Mean of Adjusted volume

adjusted log initial Regression associated with log
Categories volume return coefficient initial return

Panel A. Regressions using adjusted trading volume from day 5 to day 122
All 5.56 0.10 7.25 0.70
Before 1988 3.91 0.07 3.67 0.27
After 1988, not locked 4.37 0.05 4.62 0.22
With lockup 6.79 0.12 8.78 1.04
Panel B. Regressions using adjusted trading volume from day 129 to day 500
All 5.17 0.10 5.38 0.52
Before 1988 3.26 0.08 3.21 0.24
After 1988, not locked 3.54 0.05 3.12 0.15
With lockup 6.78 0.12 6.30 0.75

Mean of adjusted volume is the cross-sectional average of the time series averages of adjusted
daily trading volume. Mean of log initial return is the cross-sectional average of LIR. Initial return
is measured as the difference between offer price and first day closing price, divided by offer price.
The regression coefficient is the coefficient of LIR in the regressions relating time series average
of adjusted daily trading volumes to log onitial returns. Adjusted volume associated with log
initial return is the product of mean log initial return and the regression coefficients.

4. Conclusion

In our analysis of IPOs, we take the stance that pre-IPO owners’ prime objective is to
establish a liquid market for their shares, as a means of maximizing the market value of their
wealth. The owners attempt to accomplish this objective by optimally manipulating critical
variables including and especially share retention, underpricing, and a lockup restriction.
We develop and test hypotheses regarding the effects of, and interactions among, these
variables. Theory suggests that share retention by pre-IPO owners reduces the liquidity of
the IPO stock. To improve liquidity, pre-IPO owners underprice the issue to attract more
investors to follow the stock and trade it. Thus, we predict a positive relation between share
retention and underpricing and a positive relation between underpricing and aftermarket
trading volume. Our empirical evidence supports these predictions. In addition, we find
that the positive relations are stronger for IPOs with lockup. This evidence suggests that
underpricing improves liquidity more effectively for IPOs with lockup and thus pre-IPO
owners use underpricing for that purpose more frequently.
Finally, our arguments do not preclude other explanations for IPO underpricing. The IPO
process is complex, involving many factors. Pre-IPO owners’ motive to improve liquidity
is just one aspect of that process. Other aspects of the process, such as interactions among
the factors, may also contribute to the underpricing decision. However, our results do
indicate that underpricing is strongly related to share retention, and is negligible for IPOs
with very little retention. Therefore, it is reasonable to conclude that the share retention
decision (as well as the lockup decision) should be integrated into any theory of IPO
underpricing.
PURSUING VALUE THROUGH LIQUIDITY IN IPOS 311

Acknowledgments

Ogden is grateful for financial support provided by the UB School of Management’s 2004
Summer Research Fellowship Program. This paper is based on part of Zheng’s dissertation
completed at the University at Buffalo. The authors wish to thank William Reese and two
anonymous RQFA referees for helpful suggestions. Any remaining errors are the authors’
responsibility.

Notes

1. Here the value of their shareholdings is measured using the IPO offer price. If the market price is used, the loss
will be even smaller.
2. The 9% loss is based on the assumption that the offer price remains the same.

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