Initial public offerings and new ventures
S. Trevis Certo
Initial public offerings (IPOs) transition privately held new ventures into the arena of public trading. Firms have undertaken IPOs in over thirty countries, but the majority of IPO research involves firms in the United States (for a review of IPO research in international settings, see Ritter, 1998). In the US, privately held firms are typically owned by a small number of investors (see entrepreneur; business angel network; venture capital) and are not required to file financial statements with the Securities and Exchange Commission (SEC).
While IPOs are usually associated with new ventures, it is important to note that they also 152 initial public offerings and new ventures apply to spin offs (see spin offs), reverse leveraged buyouts, and closed end mutual funds. The majority of IPO researchers, however, typically exclude such IPOs from analysis. Research indicates that entrepreneurs serve as CEO for approximately 50 percent of IPO firms, with the remainder led by ‘‘professional’’ managers (Certo et al., 2001).
Undertaking an IPO (also known as ‘‘going public’’) transitions the private firm into a publicly traded company. With this new status of being publicly traded, shares of the IPO firm’s stock are listed on a stock exchange (e.g., New York Stock Exchange) and investors are able to buy and sell shares of the company’s stock through stockbrokers. In addition, the SEC re quires publicly traded companies to abide by certain rules and regulations, such as the requirement that such firms must file audited financial statements.
IPOs have become a rather popular financing tool; between 1980 and 2001 over 6,200 firms raised nearly $500 billion through IPOs in the United States (Ritter and Welch, 2002). Re search suggests a number of reasons for which firms undertake IPOs (Rock, 1986). First, an IPO helps the firm raise new capital. By issuing new shares to the public, the firm brings in new capital to invest in new technologies, manufacturing facilities, employees, etc. Second, the IPO helps the firm’s initial investors to diversify their investments in the firm. Specifically, executives and investors in some firms use the IPO as an opportunity to sell existing shares; presumably these investors are able to use the proceeds from such sales to invest in other types of investment vehicles. In this sense, many venture capitalists view IPOs as a primary exit strategy. Third, firms undertake IPOs to gain organizational legitimacy (Certo, 2003). Existing as a publicly traded firm may establish credibility among key stakeholders such as customers, suppliers, and employees.
Owners and executives of firms going public adhere to a standardized IPO process (for a detailed description of the IPO process, see Ellis, Michaely, and O’Hara, 1999). The first step in this process usually involves enlisting the assistance of a lead investment banker (in vestment bankers are also referred to as under writers). With the assistance of the underwriter, executives begin to draft the registration statement. The registration statement, which must be filed with the SEC, details the company’s strategy, top executives, and financial statements. The investment banker then uses this registration statement to market the firm to potential investors. The investment banker also arranges for road shows, which involve presentations by the company’s top executives to potential investors, such as mutual and pension fund managers. After these road shows, the investment banker gauges demand for the offering by querying potential investors with respect to their desires to purchase shares in the company; this process is referred to as ‘‘book building’’ (for an excellent description of book building, see Cornelli and Goldreich, 2001). Based on these queries, in vestment bankers determine the final price at which shares of the company will sell to the public. This final price is known as the IPO’s offer price.
Empirical research has determined two trends with respect to the performance of IPO firms. The first trend involves the consistent under pricing of IPOs, and the second trend concerns the consistent long term underperformance of IPO firms. The following sections detail re search examining these two trends.
Underpricing
Research suggests that on the first day of public trading, the share prices of IPO firms regularly close at prices that exceed their offer prices. This phenomenon is referred to as underpricing. A fictional example of XYZ, Inc.’s IPO will illustrate how underpricing occurs. Suppose that underwriters established an offer price of $10 per share for XYZ. At the end of the first day of trading, though, shares of XYZ closed at $13 per share. In this example, the firm raised $10 for each share of equity sold to the public. The closing price of $13 indicates, however, that the price set by investment bankers was less than the price determined by the stock market at the end of the first day of trading; this is known as IPO underpricing.
Underpricing produces consequences for both IPO firms and investors. Continuing the example of XYZ, Inc., executives of XYZ received $10 (offer price) for each share of stock sold to new investors. If the investment banker initial public offerings and new ventures 153 had priced the shares efficiently, however, executives of XYZ would have received $13 for each share sold to new investors. In other words, efficient pricing would have enabled executives to receive an extra $3 per share to invest in new technologies, equipment, employees, etc. Instead, this extra $3 is captured by the initial investors, who purchased shares of XYZ for $10 and witnessed the price increase to $13 by the end of the first day of trading. Because the IPO firm does not capture this value, some commentators have referred to underpricing as ‘‘leaving money on the table’’ (e.g., Ritter and Welch, 2002) and questioned the efficiency of the IPO pricing process (Lowry and Schwert, 2004).
Empirical work by Ritter and Welch (2002) indicates that underpricing represents an eco nomically significant phenomenon that appears to vary with overall investor attitudes. In the 1980s, for example, shares of IPO firms were underpriced by 7.4 percent on average; under pricing during this period resulted in approximately $5.4 billion dollars being left on the table. In just 1999 and 2000, though, shares of IPO firms were underpriced by 65 percent on aver age, which resulted in over $65 billion being left on the table. Despite the prevalence of this market anomaly, relatively little is known with respect to the determinants of underpricing (Daily et al., 2003).
The Long-Run Performance of IPO Firms
Another trend associated with the performance of IPO firms involves the relative underperformance of firms in the years immediately following their IPOs. Ritter and Welch (2002) reported that the average firm going public between 1980 and 2001 trailed the general stock market by over 23 percent in the three years following its IPO. Complementing this finding, Jain and Kini (2000) analyzed a sample of firms undertaking IPOs between 1977 and 1990 and found that only about 75 percent of these firms continued to operate independently as public corporations within five years after their IPOs. In other words, more than 25 percent of these firms failed to maintain their status as publicly traded companies within five years of their IPOs.
As compared to the underpricing literature, there exists a less substantial stream of re search examining the long run underperformance of IPO firms. Jain and Kini (2000), for example, found that firms backed by venture capitalists were more likely to survive than firms not backed by a venture capitalist. Mikkel son, Partch, and Shah (1997) found that larger IPO firms enjoyed higher levels of operating performance as compared to smaller IPO firms.
Although difficult to measure, overconfidence might also represent a potential explanation for the long run underperformance of IPO firms. Specifically, it could be that both entrepreneurs and investors are overly optimistic at the time of the IPO. Such overconfidence could lead entrepreneurs to invest IPO proceeds in projects that are unlikely to reap benefits and investors to invest their capital in IPO firms with question able growth prospects.
Conclusion
Going public will continue to represent a popular financing strategy for entrepreneurs and venture capitalists as they attempt to advance their firms. The substantial body of research examining IPO firms notwithstanding, there exist several additional areas for further exploration. Future research, for example, could further examine the pricing of IPOs. While extant re search focuses primarily on prospectuses to examine IPO pricing, future research might in volve collecting primary data from investment bankers, entrepreneurs, and venture capitalists. Understanding how these important stakeholders perceive IPO firms might help in explaining IPO prices.
Complementing this research on IPO pricing, additional examinations of the long run performance of IPO firms are warranted. Specific ally, future research could examine how changes within the firm help to circumvent long run performance problems. Changes in top management team structures, for example, might help firms to adapt to the rigors of public trading. Similarly, changes in diversification levels, financial structures, strategies, and compensation systems might also influence long run performance. Studies examining these issues would 154 initial public offerings and new ventures surely benefit scholars in multiple disciplines who continue to explore the IPO process.
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