ENTREPRENEURIAL OPTIMISM AND THE MARKET FOR NEW ISSUES
| Date | 01 May 2017 |
| Author | Luís Santos‐Pinto,Michele Dell'Era |
| Published date | 01 May 2017 |
| DOI | http://doi.org/10.1111/iere.12221 |
INTERNATIONAL ECONOMIC REVIEW
Vol. 58, No. 2, May 2017
ENTREPRENEURIAL OPTIMISM AND THE MARKET FOR NEW ISSUES∗
BYLU´
IS SANTOS-PINTO AND MICHELE DELL’ERA1
University of Lausanne, Switzerland; Bocconi University, Italy
This article analyzes the impact of entrepreneurial optimism on the market for new issues. We find that the
existence of optimists generates a new reason for entrepreneurs to own equity in their firms. We show that
optimism is a natural explanation for why some new issues are underpriced and others overpriced. We also show
that the impact of optimism on entrepreneurs’ equity holdings depends on the number of optimists, absolute
risk aversion, and cash flow variance. Optimism makes entrepreneurs worse off. In contrast, optimism can make
outside investors better off when entrepreneurs signal firm value by retaining shares and underpricing.
1. INTRODUCTION
Leland and Pyle (1977) show that when entrepreneurs have private information about the
mean return of their projects, the amount of their own funds invested in the project will
be interpreted as a signal of its mean return. In equilibrium, the higher the mean return of
the project, the greater the amount of equity that will be retained by the entrepreneur and the
higher will be the equity market valuation of the firm. However, signaling is costly because
entrepreneurs are risk averse, and those with high expected value projects do not obtain full
insurance. Thus, signaling reduces the welfare losses caused by asymmetric information in equity
markets but at a cost (second-best solution).2
Entrepreneurs’ accurate beliefs about the value of their projects are the cornerstone of the
signaling mechanism. Yet, scholarly work shows that entrepreneurs are typically overconfident
about their skills and optimistic about the chances that their projects will be successful—for
example, Cooper et al. (1988), Wu and Knott (2006), and Landier and Thesmar (2009).
Optimistic individuals are more likely to become entrepreneurs according to Gentry and
Hubbard (2000), Hurst and Lusardi (2004), Puri and Robinson (2007), and Cassar and Friedman
(2009). There is also considerable evidence that entrepreneurs are more optimistic than other
individuals. For example, Busenitz and Barney (1997) and Lowe and Ziedonis (2006) find
that entrepreneurs are more optimistic than managers. Arabsheibani et al. (2000) find that the
self-employed are more optimistic than employees.
Entrepreneurs are also considered to be optimistic because they are not deterred by the
evidence of unfavorable returns to entrepreneurship. Dunne et al. (1988) show that most
businesses fail within a few years. Hamilton (2000) finds that after 10 years in business, median
∗Manuscript received November 2012; revised February 2015.
1We are thankful to the editor, Francesco Squintani, two anonymous referees, Andrea Galeotti, Amit Goyal, Mark
Grinblatt, Chuan Hwang, Andreas Kohler, David Martimort, Dirk Niepelt, Pascal St-Amour, Katrin Tinn, and seminar
participants at University of Lausanne, Nova School of Business and Economics, University of Bern, Young Swiss
Economists Meeting 2012, Swiss Society of Economics and Statistics Annual Meeting 2012, Royal Economic Society
Annual Conference 2012, 27th Annual Congress of the European Economic Association 2012, 67th European Meetings
of the Econometric Society 2013, World Finance Conference 2014, Research in Behavioral Finance Conference 2014,
and 42nd EARIE Conference 2015. Please address correspondence to: Lu´
ıs Santos-Pinto, Faculty of Business and
Economics, University of Lausanne, Internef 535, CH-1015, Lausanne, Switzerland. Phone: 41-216923658. Fax: 41-
216923435. E-mail: LuisPedro.SantosPinto@unil.ch.
2When outside investors are risk neutral, entrepreneurs are risk averse, and the mean return of entrepreneurs’
projects is known by both sides of the market, entrepreneurs are fully insured and welfare is maximized (first-best
solution).
383
C
(2017) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social
and Economic Research Association
384 SANTOS-PINTO AND DELL’ERA
entrepreneurial earnings are 35% less than those on a paid job of the same duration. Moskowitz
and Vissing-Jorgensen (2002) find that the returns from entrepreneurship are, on average, not
different from the return on a diversified publicly traded portfolio (private equity puzzle).
In this article, we study the impact of entrepreneurial optimism on the market for new
issues. To do that, we extend Grinblatt and Hwang (1989) by including optimists and show how
optimism affects the pricing of new issues, retained shares, and welfare.
Leland and Pyle (1977) propose the first model of equity market signaling. In this article, the
only parameter unknown to outside investors is the mean return of a project, and entrepreneurs
signal firm value by retaining shares. Grinblatt and Hwang (1989) study the problem of en-
trepreneurs trying to signal mean and variance simultaneously. Two signals are needed to
communicate these two pieces of information: retained shares and the degree of underpricing.3
In Leland and Pyle (1977) as well as in Grinblatt and Hwang (1989), entrepreneurs are risk
averse and have enough wealth to finance their projects entirely. As the need for external funds
is assumed away, these papers focus on the role of the equity market in providing entrepreneurs
an opportunity to diversify idiosyncratic risk.
We model the behavior of an entrepreneur who owns the rights to an investment project that
requires a date 0 capital outlay of k. A project iyields a random cash flow of ˜xiin date 1 and
an independent random cash flow of μi+˜yiin date 2. There exist two types of projects, that is,
i=1,2. The low expected value project has mean μ1and cash flow variance σ2
1, and the high
expected value project has mean μ2and cash flow variance σ2
2,with0<k
1
2<∞and
0
2
i<∞,fori=1,2. There exist three types of entrepreneurs. A realist with a low expected
value project knows his project has mean μ1and cash flow variance σ2
1. A realist with a high
expected value project knows his project has mean μ2and cash flow variance σ2
2. An optimist
believes he has a project with mean μ2and cash flow variance σ2
2, when, in fact, he has a project
with mean μ1and cash flow variance σ2
1.
Entrepreneurs are risk averse and, to achieve a more diversified portfolio, market the projects
to the investing public. There are two signals that can be employed, each observed by market
participants in date 0. The first is the fraction of the new issue retained by the entrepreneur,
denoted by α. The second is the amount by which the new issue is underpriced, denoted by D.
The mean and the variance of a project’s cash flows are unknown to outside investors in date 0
but they are revealed in date 1 with probability r∈(0,1]. Outside investors are risk neutral and
know about the existence of optimists but do not know whether a particular entrepreneur is an
optimist or not. Outside investors observe retained shares α, underpricing per share D, and the
offering price of the new issue Pand use this information to decide whether to buy equity or
not.
Section 3 describes the impact of optimism on the market for new issues when outside
investors are able to directly observe entrepreneurs’ beliefs. We show that the existence of opti-
mists generates a new reason for entrepreneurs to own equity in their firms. The intuition behind
this result is as follows: When outside investors are able to directly observe entrepreneurs’ be-
liefs and there are no optimists, all entrepreneurs choose to hold zero equity in their own firms
to avoid facing any idiosyncratic risk. Let us now assume that there exists a fraction θ>0of
optimists among entrepreneurs who believe they have a high expected value project and that
outside investors know about this. If that is the case, then outside investors are only willing
to pay a price of (1 −θ)μ2+θμ1=μ2−θμ,withμ =μ2−μ1, for the equity of an en-
trepreneur who believes (either realistically or because he is an optimist) he has a high expected
value project. Faced with an equity price of μ2−θμ, such an entrepreneur prefers not to fully
insure because he thinks (either realistically or because he is an optimist) that the project is
underpriced by outside investors by θμ. Thus, regardless of risk aversion, the existence of
optimists implies that entrepreneurs who believe they have a high expected value project retain
shares and face idiosyncratic risk.
3Welch (1989), Allen and Faulhaber (1989), and Chemmanur (1993) are other prominent signaling models that can
explain underpricing.
ENTREPRENEURIAL OPTIMISM AND NEW ISSUES 385
Throughout the rest of the article, we assume outside investors cannot directly observe
entrepreneurs’ beliefs and therefore information is asymmetric.
Section 4 studies the impact of optimism on the market for new issues when only the mean of
a project’s cash flows is private information of the entrepreneur. To perform this analysis, we
assume the two types of projects have the same variance, that is, σ2
1=σ2
2=σ2, and σ2is known
to outside investors in date 0. In addition, we assume a project’s mean is unknown to outside
investors in date 0 but becomes known in date 1 with certainty, that is, r=1. This special case
illustrates the model’s relation to Leland and Pyle (1977).
In an efficient separating equilibrium, realists with low expected value projects do not retain
shares, whereas realists with high expected value projects and optimists retain αshares. The
optimal response of outside investors to the fact that optimism raises the proportion of low
expected value projects in the group of entrepreneurs who retain shares is to lower the stock
price offered to that group. Hence, the existence of optimists makes it less profitable for realists
with high expected value projects to sell equity because it reduces stock prices.
Note that entrepreneurs who retain shares do not, on average, misprice the (1 −α) shares
sold to outside investors since they receive a price of μ2−θμ for their equity. However, a
realist with a high expected value project underprices the (1 −α) shares sold to outside investors
by θμ, whereas an optimist overprices them by (1 −θ)μ. Hence, the existence of optimists is
a natural explanation for why some new issues are underpriced whereas others are overpriced.4
Optimism also affects entrepreneurs’ equity holdings α. When the fraction of optimists among
entrepreneurs who signal is not too large, the more optimists there are, the fewer shares are
retained. In contrast, when the fraction of optimists among entrepreneurs who signal is large
enough and absolute risk aversion is either constant or increasing in wealth, the more optimists
there are, the more shares are retained.
Next, we turn to the welfare implications of optimism. Optimism leaves unchanged the utility
of a realist with a low expected value project. It makes a realist with a high expected value
project worse off. It either leaves unchanged or lowers the expected utility of an optimist if one
takes the perspective of an outside observer who knows the actual type of a project. Finally,
optimism has no effect on the expected payoff of outside investors.
Section 5 describes the impact of optimism on the market for new issues when both the mean
and the variance of the project’s cash flows are private information of the entrepreneur. To keep
the model close to Grinblatt and Hwang (1989), we assume cash flows are normally distributed
and entrepreneurs have constant absolute risk aversion. In addition, we assume a project’s type
is revealed in date 1 with probability r∈(0,1). This last assumption plays a critical role. First, it
implies that there exists a primary (date 0) and a secondary (date 1) market for assets. Second,
if ris 0 or 1, underpricing cannot be a signal.
In an efficient separating equilibrium, realists with low expected value projects retain no
shares and do not underprice. Realists with high expected value projects and optimists signal by
retaining shares in date 0 and the use of underpricing as an additional signal in date 0 depends
on how large the variance of the high expected value project is.
When the variance of the high expected value project is not too large, realists with high
expected value projects and optimists do not, on average, misprice the (1 −α) shares sold to
outside investors in date 0. However, a realist with a high expected value project underprices
the (1 −α) shares sold to outside investors in date 0 by θμ and, if the project’s type is not
revealed, the αshares sold in date 1 by θμ. An optimist overprices the (1 −α) shares sold
indate0by(1−θ)μ and, if the project’s type is not revealed, the αshares sold in date 1 by
4The underpricing of initial public offerings (IPOs) is a well-documented fact of empirical equity market research.
Whereas most IPOs are underpriced, some are overpriced—see Krigman et al. (1999) and Leite (2004). A famous
example of overpricing is the IPO of Facebook in 2012. According to Allen and Morris (2001) IPOs “have received
a great deal of attention in the academic literature. The reason perhaps is the extent to which underpricing and
overpricing represent a violation of market efficiency. It is interesting to note that although game-theoretic techniques
have provided many explanations of underpricing, they have not been utilized to explain overpricing. Instead the
explanations presented have relied on relaxing the assumption of rational behavior by investors.”
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