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Unformatted text preview: better off by holding only a small fraction of the firm’s shares
The entrepreneur knows the true expected return of the project, but outside investors do not.
Outside investors will price each project according to their perception of the average expected profitability
But then, the average expected returns of projects offered will be low, as only low return projects are offered
Some good projects not financed due to adverse selection
30 Signaling with Retained Ownership in IPOs However, the α% of shares retained by the entrepreneur is a credible signal to communicate his private information
All projects have similar risk, but some have high expected returns and others have low expected returns
Holding 10% of shares is more costly for an entrepreneur with a low expected return project than for one with a high expected return project, as risk is similar
Entrepreneurs with high ER projects will retain a large fraction of the firm’s equity, and those with low ER projects will retain a low fraction.
31 Signaling with Retained Ownership in IPOs Equilibrium market valuation:
If the entrepreneur retains high ownership in the firm, the market will infer that the project has high ER
If the entrepreneur retains low ownership in the firm, the market will infer that the project has low...
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- Spring '13