Why Include Warrants in New Equity Issues? A Theory of Unit Ipo's

Abstract

We develop a theory of unit IPOs, in which the firm going public issues a package of equity with warrants. We model an equity market characterized by asymmetric information, where insiders have private information about the riskiness as well as the expected value of their firm's future cash flows. We demonstrate that, in equilibrium, high risk firms issue "units" of equity and warrants, and the package of equity and warrants is underpriced; lower risk firms, on the other hand, issue underpriced equity alone. An important feature of our model is that, in contrast to the existing literature, underpricing is used as a signal in equilibrium in the context of a one-shot equity offering. While the model is developed in the context of IPOs of equity, it is also applicable with minor modifications to the case of seasoned equity offerings packaged with warrants; further, the intuition behind the model generalizes readily to provide a new rationale for packaging call option-like claims with other risky securities (e.g., convertible debt, debt with warrants) as well.

JEL Classification: D82