Determinants of Contract Choice: The Use of Warrants to Compensate Underwriters of Seasoned Equity Issues

Abstract

The issuer's decision to include warrants as compensation to underwriters is studied for a sample of 1,991 negotiated firm commitment issues of seasoned equity. Using a two-stage logit model to correct for self-selection bias, we find direct evidence that warrant compensation functions as a bond, substituting for reputational capital and enabling the underwriter to certify the issue price. To a lesser degree, the decision also is affected by regulations on underwriter compensation and on the use of underwriter warrants. Issuers' decisions are consistent with an objective of minimizing total underwriting cost, including cash compensation, warrants, and underpricing. COMPENSATION TO UNDERWRITERS OF equity issues can be in either cash in the form of a spread, or a combination of cash spread plus warrants to purchase new shares of the issuer at a future date. Use of warrant compensation has been puzzling and controversial for several reasons: (1) since expectations about future stock performance may diverge, the value of cash compensation is easier for the issuer and the underwriter to agree upon; (2) legal restrictions on resale and exercise of warrants used as compensation reduce their value to the underwriter; (3) since the exercise price is tied to the issue price, warrants reinforce the underwriter's incentive to underprice.Previous research offers three hypotheses for use of warrant compensation. First, in an early study of securities markets, the U.S. Securities and Exchange Commission (SEC) (1963a, at 500-512; and 1963b) hypothesizes that the market for underwriting services is segmented between small and large issuers. Large issuers enter into cash compensation contracts with well-established underwriters, whereas small issuers are constrained to deal with less well-established underwriters who demand warrant compensation. The SEC suggests that warrants are used to mislead small issuers about the value of

Underwriter warrants, underwriter reputation, and growth signaling

“…As noted earlier, Booth and Smith (1986), Barry et al (1991), and Dunbar (1995), each using IPO data, and Ng and Smith (1996), studying seasoned issues, offer some support for these assertions. These studies, however, derive and test multivariate regression models emphasizing underwriting cost estimates rather than market responses to relevant but diverse information.…”

“…His results suggest that warrants are used to enhance underwriter certification and reduce underpricing, which should be more valuable for smaller firms. Ng and Smith (1996) extend the discussion by summarizing the three hypotheses for the use of WBC which have dominated the literature (segmentation, circumvention, and certification hypotheses) and demonstrate that while the three hypotheses may represent distinct and important determinants of a contract choice, they are not unrelated.…”

“…2 Previous literature on underwriter certification suggests that underwriters help reduce information asymmetry through certification in the US (Booth and Smith 1986;Beatty and Ritter 1986;Chemmanur and Fulghieri 1994;Ng and Smith 1996;Puri 1996;Dunbar 2000;McLaughlin et al 2000), the UK (Slovin et al 2000), and Japan (Cooney et al 2003). For instance, Booth and Smith (1986) argue that if the net benefit from revealing the true issuing-firm value of an SEO, after accounting for the cost of hiring a high-quality underwriter, exceeds the benefit of hiding the true issuing-firm value, then the firm will hire high-quality underwriters.…”

“…Barry et al (1991) claim that underwriters accept warrants as a substitute for higher cash spreads to circumvent maximum compensation guidelines of the NASD. While Dunbar (1995) reports that the decision to include warrant compensation tends to minimize issue costs, Ng and Smith (1996) show that regulation matters in terms of the choice between WBC and CBC. Because our major focus is to examine the usage of warrants as a signaling mechanism of future growth opportunities, however, we do not address the issue of regulatory circumvention in this article.…”

Underwriter choice and earnings management: evidence from seasoned equity offerings

“…Second, previous literature suggests that underwriters help reduce information asymmetry through certification in the United States (Booth & Smith, 1986;Beatty & Ritter, 1986;Chemmanur & Fulghieri, 1994;Ng & Smith, 1996;Puri, 1996;Dunbar, 2000;McLaughlin et al, 2000), the United Kingdom (Slovin, Sushka, & Lai, 2000), and Japan (Cooney, Kato, & Schallheim, 2003). 7 McLaughlin et al (2000 suggest that hiring a low-quality underwriter is a bad signal to the market.…”