M&As & IPOs

Mergers & Acquisitions (M&As) and Initial Public Offerings (IPOs) are the two primary exit strategies used by entrepreneurs and venture capitalists to cash out their investments in a startup. In an M&A, a company merges with or is purchased by another company. In an IPO, a company goes public on the stock market, and investors can sell their shares publicly.

Introduction

M&As and IPOs are the two primary exit strategies used by entrepreneurs and venture capitalists to cash out their investments in a startup firm. M&As have been studied in two parallel literature streams in strategy and finance. Much of the finance M&A research concerns the effects of M&As on stock price valuations. Researchers have consistently found that the acquirer's stock price decreases and the target's stock price increases upon the announcement of an M&A, especially when the acquirer issues stock to buy the target. Earlier research argues that this phenomenon is due to the agency problem of the target managers because they overpay the target in order to have more assets under their control. Recent research finds that it is more consistent with market misvaluation: the acquirer's stock is usually overvalued by the market while the target's stock is undervalued. It's optimal for the acquirer to issue overvalued equity to buy the undervalued target.

The strategy M&A literature focuses on the innovation outcomes of M&A, the transferred knowledge, and inventors’ performance. Much of this literature views acquisition as a mode through which firms may gain access to knowledge and capabilities that they lack. Furthermore, this literature has focused on acquisitions of entrepreneurial startups. From the perspective of acquirers of startups, acquisitions offer a critical path to internalizing novel and advanced technologies embedded in startups. From the perspective of the startups, acquisitions are a valuable exit strategy toward economic value capture. 

Research on IPOs has yielded a strong understanding of the basic makeup of the firms that choose to IPO. Over the last 30 years, almost 40 percent of the firms that went public were technological firms, raising more than $230 billion in gross proceeds. Studies typically find that firms are more likely to go public if they are larger in size, have access to private financing, have higher productivity (TFP) and sales growth, and operate in less competitive and more capital-intensive industries. 

IPOs provide an important source of capital for technological companies to fund operations and, at the same time, provide liquidity for early-stage investors (such as venture capitalists) and founders. This liquidity provides the rewards for venture capitalists and motivates investment in early-stage companies. In the 1980s and 1990s in the U.S., this framework was very descriptive of actual practice for many entrepreneurial firms. Since the tech-stock bubble burst in 2000, however, this framework is increasingly at odds with practice. Instead, venture capitalists have been operating with a "build to sell" model in which they exit from an investment in a successful portfolio firm via a trade sale (a sale in which the entrepreneurial firm sells out to a larger firm in the same or a related industry) rather than exiting via an IPO.

IPO Volume 1980-2015As a result, IPOs have seen a secular decline. In the U.S., the average number of IPOs has dropped from 310 per year between 1980 and 2000 to 110 per year between 2001 and 2014. Gao, Ritter, and Zhu (2013) document that this slowdown over the last decade has affected primarily the probability of smaller firms doing an IPO (see figure 1 in their paper, presented in an updated version here), with a less dramatic effect on larger firms. 

Experts frequently attribute this lower level of IPO activity since 2000 to a changed regulatory environment, pointing to the Sarbanes-Oxley Act of 2002 in particular for increasing the costs of being publicly traded. The Jumpstart Our Business Startups (JOBS) Act of 2012 was signed into law to reduce some of these burdens, especially for Emerging Growth Companies, defined as companies with less than $1 billion in annual revenue that have recently gone public. Studies also suggest that the above decline may be driven by a change in the nature of the economy in which the importance of bringing products to the market quickly has increased dramatically. As a result, smaller firms are more likely to sell themselves instead of going public and remaining independent.

Moving beyond these basic descriptive characteristics, there is a vast academic literature that explores various aspects of the IPO markets, with most of the focus on underpricing and the long-term performance of IPO firms. Underpricing is one of the most robust and puzzling findings in this field. Between 1980 and 2013, 7,866 IPOs of U.S. firms were underpriced by an average of approximately 18 percent. Entrepreneurs, this finding suggests, are, on average, leaving money on the table. This underpricing appears to occur in every country; Ritter (2013) assembled sources for evidence on average underpricing in 52 different countries. The common explanation for this underpricing is that retail investors face a winner's curse: they are allocated more shares from overvalued IPOs and fewer shares from underpriced IPOs. Therefore, IPO underpricing is needed for retail investors to break even; without it, they have no incentive to participate in the IPO market. 

While research has shown that IPOs, on average, underperform other stocks in the three years after going public, there is also evidence of strong cross-sectional patterns. Specifically, the returns on larger IPOs are similar to those of other stocks with similar market cap and value-versus-growth characteristics. Small firm IPOs have underperformed dramatically, in the 1980s, the 1990s, and beyond. IPOs are also more common following market rises, demonstrating some market timing ability. The low returns on small firm IPOs and the difficulty so many of them have had in generating profits suggest that many private small firms are indeed better off selling out rather than remaining independent and going public. These patterns have been documented in Europe, as well (Ritter, Signori, and Vismara 2013).

Characteristics of firms following an IPO are also the subject of a substantial body of research. Generally, despite the benefits of access to capital, firms tend to experience a decline in operating performance in the years following the IPO, as well as a decline in productivity. In particular, the productivity pattern exhibits an inverted U shape, in which productivity increases steadily in the years prior to the IPO, reaches a peak in the IPO year, and declines steadily in subsequent years. Beyond a decline in productivity, IPO firms, on average, also underperform similar "matched" peers in terms of both stock market and accounting performance  (Ritter 1991) (Jain and Kini 1994) (Loughran and Ritter 1997). Lastly, going public changes the manner in which firms pursue innovation. Specifically, it seems that firms tend to rely more on acquisition to innovate following the IPO, rather than pursuing innovation internally.  

Many unresolved questions remain in the literature. Among them, researchers have not determined why stock valuations do not settle at the correct price to reflect the "fundamental value" immediately after the announcement of M&As or IPOs, or why stock prices are misvalued in the first place. The reasons it takes such a long time (three to five years) for the market to correct the misvaluation in the stock price are even more puzzling. Additionally, much work remains to be done to further understand the role of IPOs in the innovation ecosystem and their effect on employees and other stakeholders in the firm, as well as the effects of going public on firm operations. Finally, other remaining issues include: the definitive reasons behind the continued low level of activity in IPOs and a corresponding increase in M&A activity in recent years, and how and when a firm invests in innovation and whether such investments have any relationship to the IPO of the firm. While some very recent papers have taken initial steps in these directions, much remains to be done, particularly if we want to think more broadly about how the IPO market could spur economic activity and growth.

Discussion

Mergers and Acquisitions (M&A)

It is widely documented by researchers that the economic benefits of M&As are largely accrued to targets’ shareholders. Target firms gain an average of 16 percent in stock returns in the three-day window around the M&A announcement (Andrade, Mitchell, and Stafford 2001). The acquirers’ shareholders, however, experience negative stock returns in the same time window. After the M&As, the negative stock performance for acquirers’ shareholders typically persists and becomes worse for stock-financed mergers. Mitchell and Stafford (2000) find that the three-year post-merge abnormal returns for acquiring firms from 1961 to 1993 is 5 percent. Similarly, Loughran and Vijh (1997) show that acquirers experience an abnormal return of -24.2 percent for stock-financed mergers and 18.5 percent for cash mergers in the five-year period after mergers. Rau and Vermaelen (1998) find three-year abnormal returns of -17.3 percent for glamor acquirers (i.e., acquirers with high market-to-book ratios) and 7.6 percent for value acquirers (i.e., acquirers with low market-to-book ratios). 

Several explanations have been proposed for the low levels of financial return to acquirers’ shareholders. Within the finance literature, the hubris hypothesis suggests that acquirer managers are overconfident about their ability to manage the merged firm and overestimate the synergy form the M&A. As a result, they overpay for the target to complete the deal (Roll 1986). Alternatively, the free cash flow hypothesis states that managers are reluctant to pay out free cash flows to shareholders (Jensen 1986). Instead, they engage in value-destroying M&As to increase the firm size because their private benefits of control increase with the size of the firm. 

A recent study, however, offers a different view. Shleifer and Vishny (2003) argue that most M&As are driven by the market misvaluations of the acquirer and the target's equity. If the acquirer's stock is overvalued by the market while the target's stock is undervalued, it is in the best interest of acquirer shareholders to issue overvalued equity as a cheap currency to buy the target. This theory can explain why there is a negative announcement return for the acquirer and a positive return for the target: the announcement of the deal tells the market that the acquirer's stock is likely overvalued and the target's stock is undervalued. It also explains the negative long-run stock returns. As time goes by and more information comes out, the market gradually corrects the misvaluation and the acquirer's stock price will go down, hence the negative long-run stock return. Researchers are unsure, however, why it takes such a long time (three to five years) for the acquirer's stock price to come down. If the market is rational, investors should realize that the acquirer's stock is overvalued as soon as the M&A is announced, and the correction should take a relatively short time.

Strategy scholars have highlighted a different set of issues associated with acquisitions. Assuming that M&As are mechanisms for transfer and reconfiguration of valuable resources and capabilities from target to acquiring firm (Capron, Dussuage, and Mitchell 1998) (Karim and Mitchell 2000), the relatedness hypothesis suggests relevance of resource portfolio of targets to acquirers as an important contingency factor for financial return. In this perspective, the potential for creating either economies of scope or scale as a result of combining the two firms’ resource bases leads to value creation. Consistent with this idea, Singh and Montgomery (1987) show that related acquisitions are more likely to create economic value relative to unrelated acquisitions. Barney (1988) adds that acquiring a related target results in abnormal returns for the shareholders of acquiring firms only when the firms enjoy private and unique synergistic cash flows. 

Financial performance of acquisitions may be also eroded due to challenges associated with post-acquisition integration. During the post-acquisition phase, acquiring firms need to coordinate closely with acquired firms’ management to integrate and combine the two firms. This process typically entails blending different corporate cultures, unifying different financial and control systems, and identifying appropriate working relationships. Unsuccessful post-acquisition integration may hurt financial outcomes of acquisitions, given that it disrupts the working routines of the acquired firm, reduces employee motivation, and leads to major culture conflicts. Recent research has shown, however, that factors such as acquiring firm’s integration capabilities (Hayward 2002) (Zollo and Singh 2004), timing and speed of integration, and provisions of structural independence (Puranam, Singh, and Chaudhuri 2009) may dampen these negative consequences.  

M&A Innovation Outcomes

Performance consequences of M&A may be evaluated based on various innovation metrics. This literature has focused primarily on firms’ patents as a signal of innovation output. The first generation of research maintains that acquisition-active firms have a lower level of patenting (Hitt, Hoskisson, Ireland, and Harrison 1991), given that acquisitions may not only reduce managers’ motivations to pursue internal innovation, but also affect availability of financial resources for parallel pursuit of internal R&D projects. This early stream of research, however, was not clear on whether an acquisition was pursued for the purposes of technology sourcing, or whether the target firm possessed relevant technologies. Furthermore, when studying the overall R&D output of acquisition-active firms, this early stream did not tease the effect of lower ex-ante innovation output leading to more acquisition activity from the effect of acquisition activity leading to less ex-post innovation output.

Current research in the area has provided a different and more complete perspective on the innovation outcomes of M&A. Importantly, the strategic fit between acquiring and target firm as well as possession of technological capabilities by targets have been noted as critical conditions for achieving post-acquisition innovation outcomes. Ahuja and Katila (2001) argue that if an acquisition is not conducted for the purposes of technology sourcing and if the acquired firm does not have any relevant technological components, it is unlikely that the acquisition can positively affect a firm’s innovation outputs. However, when the acquired firm brings some technological components to the acquiring firms, the increase in the size of the firm’s knowledge base leads to more knowledge combinations. Thus, they hypothesize that only technological acquisitions increase the intensity of a firm’s post-acquisition patenting. Following Ahuja and Katila (2001), the focus of research papers became technological acquisition of firms, rather than deriving general results about innovation behavior of firms based on a sample of acquisitions that were not conducted for technology sourcing objectives. Subsequent research suggested that in addition to the size of the technology base of the target, post-acquisition patenting intensity is associated with relatedness between patent portfolios of the two firms (Cassiman et al. 2005) (Makri et al. 2010). Valentini (2012), however, warns that if there is a shift in the firm’s incentive structure following an acquisition, the quality of patents may decrease despite the increase in their intensity. 

Researchers have also studied new product introduction as another innovation outcome. In studying the medical sector, Karim and Mitchell (2000) find that acquisition-active firms are more likely to introduce new products. The rationale is that acquisitions enable firms to access resources that are both similar to and distinct from their current resource portfolio, and thus broaden the opportunity set for new product introduction. Karim (2009) elaborates on this effect by showing that although many new products may originate from internal units of firms, acquisitions provide key ingredients for their innovation, resulting in more innovation from acquisition-active firms. In a detailed case study of Johnson & Johnson, Karim and Mitchell (2004) provide many interesting anecdotes related to how new product innovation is enhanced when a firm’s internal knowledge development is accompanied by acquisitions. 

Another set of papers has examined the effects of acquisitions on inventor productivity. Following an acquisition, the innovative activity of firm’s inventors is typically disrupted. Ernst and Vitt (2000) find that the size of the acquired company, acquisition experience of the buying company, and cultural differences between R&D departments may negatively influence inventors’ productivity. They report that one-third of key inventors typically leave after an acquisition. Similarly, Kapoor and Lim (2007) find that inventors of acquired firms are less innovation productive than inventors of non-acquired firms due to the changes in the incentive structure of the two firms. 

M&As of Entrepreneurial Startups

A budding stream of research has focused particularly on the implications of M&As for entrepreneurial startups. As buyers, entrepreneurial startups typically have a smaller role compared to other more established firms (Arikan and McGahan 2010). This smaller role is largely due to their limited financial resources and lack of an acquisition capability. However, as sellers, entrepreneurial startups are active acquisition participants and mainly capture economic value through markets for technology and corporate control. 

Although much of the early academic literature has used a framework in which a successful entrepreneurial firm will go public at the appropriate stage in its life-cycle, firms are increasingly selling out in trade sales rather than going public and remaining independent firms. Being acquired is now an important alternative to going public for most firms (Arikan 2003).

M&A Waves

There have been several merger waves in the U.S. in the past few decades, and each wave was different. In the 1960s, there was a "conglomerate" wave, in which firms acquired targets from other industries to form large conglomerates. This type of merger is usually financed by stocks and it coincides with high stock market valuations. In the 1980s, the U.S. experienced a different type of merger wave that was characterized by hostile takeovers. The acquirers in this wave usually bought targets using cash raised by selling junk bonds. Finally, the merger wave in the late 1990s was characterized by stock-financed transactions and same-industry mergers. More research is needed in this area to determine the drivers of different merger waves.

IPO Introduction

IPO markets play an important role in the innovation ecosystem. Over the last 30 years, almost 40 percent of the firms that went public were in fact technological firms, raising more than $230 billion in gross proceeds.1 Tapping the equity markets is particularly important for innovative firms, which are more likely to suffer from financing constraints. As argued by Arrow and demonstrated empirically, R&D is likely to be more sensitive to financing constraints than other forms of investments due to information problems, skewed and uncertain returns, and the potentially scant collateral value of intangible assets (Arrow 1962) (Brown, Fazzari, and Petersen 2009) (Himmelberg and Petersen 1994) (Mulkay, Hall, and Mairesse 2001).

Secular Decline in IPOs

IPOs come in waves. Hot issue markets are characterized by a large number of IPOs and high levels of initial returns, with average underpricing of 48.4 percent. In cold markets, IPO underpricing is low, and the number of firms going public is small. Historically speaking, in the U.S. the average number of IPOs has dropped from 310 per year between 1980 and 2000 to 103 per year between 2001 and 2013. There was a significant peak during the internet bubble period between 1999 and 2000, during which 803 companies went public in the U.S. in these two years combined, raising about $123 billion. Gao, Ritter, and Zhu (2013) document that the slowdown over the last decade since then has primarily affected the probability of smaller firms doing IPOs. 

These waves and slowdowns are accompanied by equally large shifts in the composition of firms within the waves. For example, technology firms accounted for 25 percent of the IPO market in the 1980s, up to 72 percent during the internet bubble, and then down again to 29 percent in 2001. Even in the resurgent IPO markets of 2013 and 2014, tech companies have represented a low percentage of IPOs, with biotech company IPOs at an all-time high. By comparison, the hot issue market of 1980 consisted primarily of natural resource firms (Ritter 1984). While conventional wisdom may suggest that the quality of firms may vary in periods of high issuance activity, research has not found much evidence to support this idea (see for example, Helwege and Liang 2004 and Loughran and Ritter 2004). 

In April 2012, the Jumpstart Our Business Startups (JOBS) Act was passed into law. One of the ideas behind the law was to ease the burden of earlier securities regulations such as the Sarbanes-Oxley Act in 2002 which increased the regulatory compliance cost and may have affected the probability of smaller firms staying away from the IPO market.  Gao et al. (2013), however, suggest that the decline in the IPO market is driven by a change in the nature of the economy, in which the importance of bringing products to the market quickly has increased dramatically, leading to smaller firms finding better economies of scope by selling themselves to larger firms, frequently public acquirers, instead of going public themselves.

In "Where Have All the IPOs Gone?", Gao, Ritter, and Zhao (2013), present an alternative explanation for the prolonged low level of small company IPO activity that has existed since 2000. They posit that there has been a structural change whereby getting big fast is more important than it used to be, especially for technology firms. They argue that organic growth takes too long for a company with a hot new technology. Rather than going public and remaining as an independent firm, the company finds that its value-maximizing strategy is to sell out in a trade sale. The acquiring firm is willing to pay top dollar because it can create more value by rapidly integrating the new technology into its existing products, generating greater sales because it can certify the product with its brand name and use an extant marketing organization, rather than needing to hire new employees to expand. 

Why and When Firms IPO

A natural first question relates to why firms choose to go public. A primary answer is the desire to raise equity capital and create a public market in which the founders and other shareholders can convert some of their wealth into cash at a future date. Going public also often comes at the cost of losing control and dealing with the complexities of the public market. For firms that are buyout-backed or VC-backed, however, going public can give management more control.

A more complex question is when firms choose to IPO and what characterizes those firms. The extant research on this question is deep, and the answers many and varied. For example, Chemmanur and Fulghieri (1999) imply that larger and more capital-intensive firms, those with riskier cash flows, and those operating in industries characterized by less asymmetric information are more likely to go public. Bhattacharya and Ritter (1983) and Maksimovic and Pichler (2001) suggest that firms with greater existing market share and those operating in industries characterized by a lower degree of competition are more likely to go public. Spiegel and Tookes (2007) predict that firms will finance projects with the greatest revenue-generating ability privately, and will then go to the public markets only when more modest innovations remain. Finally, Clementi (2002) argues that firms go public as a result of a positive and persistent productivity shock that increases the cost to the firm of operating at a suboptimal scale, implying that firms characterized by greater productivity, output growth, and capital expenditures are more likely to go public.

Chemmanur, He, and Nandy (2010) find empirical support for the above theories using U.S. Census microdata and find that firms that are larger in size, have access to private financing, have higher total factor productivity (TFP) and sales growth, and operate in less competitive and more capital-intensive industries are more likely to go public.

Overall, the literature suggests that firms go public in response to favorable market conditions, but only if they are beyond a certain stage in their life cycle.  Pagano, Panetta and Zingales (1998) find that within a sample of Italian firms, larger firms in industries with high market-to-book ratios are more likely to go public, and firms seem to go public primarily to reduce the cost of credit. Lerner (1994) studies the biotech industry and finds that market-to-book ratios have, indeed, a substantial effect on the decision to go public. Although market-to-book could reflect improved growth opportunities, investor sentiment may also drive valuations upward, opening a "window of opportunity" to which firms respond by issuing equity (Baker and Wurgler 2000). Lowry (2003) finds evidence that both growth opportunities and investor sentiment play an important role in explaining aggregate IPO volume.  

IPO Underpricing

It is widely documented that IPOs are underpriced, meaning that the offer price is on average lower than the first-day trading price. Of the IPOs of U.S. firms between 1980 and 2013, 7,866 were underpriced on average by about 18 percent, implying that entrepreneurs on average leave money on the table. The typical IPO underpricing is around 15 percent, except during the internet bubble period of 1999-2000, when IPO underpricing averaged a whopping 65 percent. 

Theories of IPO underpricing can be grouped under four broad headings: asymmetric information, institutional reasons, control considerations, and behavioral approaches. The models based on asymmetric information, such as Welch (1989) and Chemmanur (1993), are best established. These models assume that the issuer is better informed about the firm’s true value, leading to an equilibrium in which higher-valued firms use underpricing as a signal.

Rock (1986) assumes that some investors are better informed than others and can, therefore, avoid participating in overvalued IPOs. The resulting winner's curse experienced by uninformed investors has to be countered by deliberate underpricing. IPO underpricing, then, is needed for retail investors to break even; otherwise, they have no incentive to participate in the IPO market. Chemmanur (1993) argues that IPO underpricing is needed to compensate investors for producing information about the new firm, without which investors wouldn't feel comfortable buying the firm's shares. Finally, Benveniste and Spindt (1989) assume that underpricing compensates better-informed investors for truthfully revealing their information before the issue price is finalized, thus reducing the expected amount of money left on the table.

How can excessive IPO underpricing and high fees charged by underwriters persist, despite the competition from many underwriters and the existence of sophisticated venture capital and private equity firms that back many of the companies that go public? Liu and Ritter (2010) answer this question with a game theory model in which issuing companies care about more than maximizing the net proceeds from the IPO. Instead, if they care about analyst coverage, they may have a strong desire to hire the underwriters with the most influential analysts in their industry. Since, by definition, there are only three underwriters with one of the top three analysts for any given company, these underwriters have some market power. Thus, even though there are many potential underwriters, each company going public faces a local oligopoly of the "best" underwriters. If these underwriters realize that they have market power, in equilibrium they will suggest a lower offer price and charge higher fees because they realize that they can win the deal even if there are many competing underwriters that would offer more attractive terms. Liu and Ritter (2010) provide empirical support for their theory by showing that VC-backed IPOs with an underwriter having a top three analyst are underpriced much more than other IPOs. They argue that VC-backed IPOs are especially concerned with analyst coverage after the IPO because VCs typically do not sell shares in the IPO. Instead, VCs distribute shares to limited partners starting six months after the IPO and fully exit within a few years.

Recent research complicates this issue, however, and shows that IPOs are actually not underpriced relative to the firm's true fundamental value. Instead, firms sell equity whenever their equity is overpriced by the market and they have the market-timing ability. For example, Purnanandam and Swaminathan (2004) find that in a sample of more than 2000 IPOs from 1980 to 1997, IPOs were priced 14 percent to 50 percent higher compared to industry peers depending on the peer matching criteria. This market-timing explanation of IPO underpricing seems to be consistent with the long-run performance of IPO firms. Ritter and Welch (2002) show that the three-year market-adjusted stock returns for IPO firms are on average -23.4 percent.

IPO Allocation

IPO allocation is an ongoing research area in finance. Benveniste and Spindt (1989) provide the first theoretical model on the topic of IPO allocation. They argue that IPO allocation allows underwriters to extract information from institutional investors about the market valuation of the IPO firm. Large institutional investors have private information about their demand for IPO shares, and this demand, in turn, affects the value of the firm in the secondary market. Of course, these institutional investors have incentives to "lowball" their offer so that they can buy IPO shares at a low price. By allocating more shares to investors who express high interest, underwriters can induce institutional investors to reveal their true valuation for the IPO firm. 

The Benveniste and Spindt (1989) model assumes that underwriters act in the best interest of IPO firms. However, the average underpricing of 18 percent in the U.S. is too high to be explained by many of the academic theories that assume there is no conflict of interest (agency problems) between issuing firms and investment bankers. Loughran, Tirn, and Ritter (2002) find that underwriters sometimes intentionally leave more money on the table and then allocate underpriced shares to their favored clients. Pulliam and Smith (2000) find that underwriters use underpriced shares to enrich buy-side clients in return for quid pro quos. Siconolfi (1997) finds that underwriters allocate underpriced shares to executives of other prospective IPO issuers so that they may get the underwriting business from these firms, a practice known as "spinning" on Wall Street. Liu and Ritter (2010) find that IPOs in which top executives have received allocations of other hot IPOs have first-day returns that were 23 percent higher than other similar IPOs. These companies are less likely to switch underwriters in a follow-on offer. 

Liu and Ritter (2011) develop a game theory model in which issuing companies care a lot about coverage from influential analysts after the IPO. The small number of underwriters that employ the most influential analysts in the issuer's industry result in these underwriters having oligopoly power, which they exercise by setting a lower offer price than needed to find investors. The underwriters make money for themselves by then allocating the underpriced shares to their most profitable clients when bookbuilding is used for pricing and allocating the shares. Bookbuilding is a procedure used in 99 percent of U.S. IPOs, as well as most other large IPOs around the world. Clients compete for these allocations by overpaying on their commissions on other trades.

Overall, these findings suggest that underwriters may use IPO allocation to their own advantage at the cost of IPO firms. The conflict of interests between underwriters and issuers and between issuer executives and shareholders is a promising area for future research on IPOs.

Long-run Underperformance

The long-run stock market performance of IPOs has attracted much attention in the literature. Whether or not IPOs underperform the stock market over the several years following equity issuance varies greatly with the statistical method used and risk-adjusted model selected. Ritter and Welch (2002) conclude that equally-weighted post-IPO returns have been low relative to broad market indices during recent decades.

In light of the debate over the long-run stock market performance of initial public offerings, it is natural to explore how the IPO, i.e., the transition to public equity markets, affects the real performance of firms. The literature has established that following the IPO, firms are experiencing a decline in performance measured by the stock market (Ritter 1991) (Loughran and Ritter 1997), productivity (Chemmanur, He, and Nandy 2010), profitability, and return on assets (Jain and Kini 1994) (Pagano, Panetta, and Zingales 1998) (Mikkelson, Partch, and Shah 1997) (Pástor, Taylor, and Veronesi 2009).

Chemmanur, He, and Nandy (2010) find an inverted U-shaped pattern of total factor productivity (TFP) change, which is broadly consistent with the performance implications of a firm increasing its scale of operations around the IPO (making use of the external financing raised), as characterized by the theoretical analysis of Clementi (2002) and Spiegel and Tookes (2007). The inverted U-shaped pattern of TFP change also implies that firms will first finance projects with the greatest revenue-generating ability privately and will then go to the public markets only when more modest innovations remain. Bernstein (2015) provides direct empirical evidence of this phenomenon, showing that the quality of internal innovation declines following the IPO, and firms experience both an exodus of skilled inventors and a decline in productivity of remaining inventors. However, the improved access to capital allows firms to attract new inventors to the firm and acquire "external innovation" through mergers and acquisitions. Understanding why such changes take place is a promising area for future research.

While it is widely documented that IPO firms underperform in the long run, researchers are unsure why it takes the market such a long time (three to five years) to correct the misvaluation. If the market is rational, investors should realize that the IPO firm's stock is overvalued as soon as the IPO is announced, and the correction should take a relatively short time. The delay in market correction could be due to investor underreaction, gradual release of the negative information to the market, or other related reasons. 

1. Statistics are based on Jay Ritter's website. The definition of a technology firm is based on Loughran and Ritter (2004) with some subsequent modifications

Future Research

Misvaluations in both M&A and IPOs

Future research should concentrate on finding a unified theory that can explain and connect the stylized facts in both the M&A and IPO literature. The recent views that both M&As and IPOs are driven by stock market misvaluations are a good start. This "market-timing" theory can explain why acquirers choose to engage in M&As even though they usually experience negative announcement returns. The theory also explains why IPO firms underperform in the three to five years after going public. However, researchers are unsure why stock prices are misvalued in the first place, why stock valuation does not come down more to reflect "fundamental value" right after the announcement, or, perhaps most puzzling, why it takes such a long time (three to five years) for the market to correct the misvaluation in the stock price.

Macro Perspectives on IPO

Future research could also focus on how the IPO market can spur new business creation and growth. The recent decline in the IPO market is worrisome. The proposed policy fixes such as the JOBS Act may not revive the IPO market if the fundamental nature of the IPO market has changed. Thus, a better understanding of the fundamentals of the market under the present economic conditions is necessary for a better formulation of policy that then may revive new start-ups and entrepreneurship.

Post-IPO underperformance

The literature shows that going public seems to affect the real performance of firms. There are many related and interesting questions about what exactly shifts at the level of the firm that generates such changes. Beyond raising capital, the IPO leads to substantial departure of employees, as well as hiring of new workers. The incentives of the employees and the management may change, as well. The focus of the firm may shift to commercialization rather than innovation due to the quarterly earnings, expected growth, and analysts’ careful coverage. Efforts to understand more about how such changes affect the decision-making within the firm seem to be a promising avenue for future research.

Miscellaneous Questions

Other interesting questions relate to the role of IPO markets in the innovation ecosystem more broadly. What is the impact of IPO markets on early-stage financing and on the tendency of entrepreneurs to start new businesses? How big is the effect? If such effects are substantial, the lack of significant IPO activity over the last decade may have considerable and real consequences beyond the availability of capital for growing companies. A better understanding of these recent changes in IPO markets is yet another interesting area for future work that has important policy implications.

Data Sources

  • SDC M&A database: Cost-dependent. The main source of M&A data is the M&A database from the Securities Data Company (SDC). A subscription is necessary to access the dataset. 
  • SDC New Issues database: Cost-dependent. This database is the main source of IPO data. A subscription is necessary to access the dataset. 
  • U.S. Census Bureau's Longitudinal Business Database (LBD)
  • EDGAR: SEC Electronic filing system; additional useful information source for complete information on IPO filings.
  • Dealogic: Cost-dependent. The best commercial database of (global) IPOs. This database, however, is very expensive.
  • EurIPO: Some European data is available for purchase.
  • tokyoIPO: Some free Japanese data is available in Japanese and English. 
  • Jay Ritter's web page: Professor Jay Ritter of the University of Florida provides free IPO data on his personal website. This website includes information on many aspects of IPOs, such as IPO underpricing, long-run stock return, price revision, underwriters, VC-backed IPOs, etc. Many of these datasets are used in Ritter’s own papers, with updates in recent years. On the website's IPO Data Page, a file of U.S. IPOs from 1975-present is available with the founding dates for each company. There are also links to many free data sources, including an Excel file with IPOs from 2000 to the present and information on the Martin Kenney and Don Patton database of U.S. IPOs from 1996 to recent years.
  • Zephyr: One of the most comprehensive databases of deal information and M&A intelligence. 

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 Page last updated 7 November 2018