Final answer:
IPOs are usually underpriced relative to eventual market prices to attract investors and account for risks. The underpricing helps to ensure the IPO's success and provides capital for the company to repay early investors and finance expansion.
Step-by-step explanation:
Initial public offerings (IPOs) are typically underpriced relative to the levels at which their prices stabilize after they begin trading in the secondary market. This underpricing is done intentionally for various reasons, including: attracting investors, ensuring a successful launch, and accounting for uncertainty and risks associated with new stock issues. After an IPO, provided the company performs well, the stock price often rises to reflect the company's true value as perceived by the public investors. The management of small companies might desire to initiate an IPO promptly to raise capital, repay early-stage investors like angel investors and venture capital firms, and fund expansion, but the inherent risks make it difficult to price the stock too high initially.
One of the critical reasons for this underpricing is the risk involved with new companies. An IPO represents the first sale of shares of stock by a firm to outside investors, and until a company is well-established and running smoothly, its stock might not garner a high price on the public market due to perceived risks. Additionally, investors often expect a discount for the uncertainty associated with new issues, hence the underpricing.