Merger and acquisitions (M&As) and initial public offerings (IPOs) are two main exit strategies that entrepreneurs, angel investors, and venture capitalists use to cash out their investments in a successful startup. The first is when a company merges with or is purchased by another company, and the second is when a company goes public on the stock market and investors can sell their shares publicly.
M&As and IPOs are two main exit strategies that entrepreneurs, venture capitalists, and other pre-IPO investors use to cash out their investments in a startup firm.
With M&A, much of the research revolves around the effects 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 the phenomenon stems from 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.
Turning to IPOs, we know a good deal about the basic makeup of the firms that choose to go public. 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. 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 (total factor productivity or TFP) and sales growth, and operate in less competitive and more capital-intensive industries (e.g., Chemmanur, He, and Nandy 2010).
In terms of the IPOs' role in the overall entrepreneurial ecosystem, we understand that 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. The latter liquidity provides the rewards for venture capitalists and motivates the investments in early stage companies. In the 1980s and 1990s in the United States, 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 in which the entrepreneurial firm sells out to a larger firm in the same or a related industry rather than remain independent.
Accordingly, IPOs have seen a secular decline for years. In the U.S., the average number of IPOs has dropped from 310 per year between 1980 and 2000 to 111 per year between 2001 and 2015. Gao, Ritter, and Zhu (2013) document that this decade-long slowdown has primarily affected the probability of smaller firms doing an IPO (see figure 1 in their paper, an updated version of which is shown here), with the effect on larger firms less dramatic.
The low level of IPO activity compared with the 1980s and 1990s has frequently been attributed to a changed regulatory environment, with the Sarbanes-Oxley Act of 2002 being singled out 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 the change in the nature of the economy where the importance of bringing products to the market quickly has increased dramatically, leading to smaller firms finding better fit by selling 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 surrounding underpricing and the long-term performance of IPO firms.
The underpricing phenomenon is one of the most robust and puzzling findings in this field, involving 7,866 IPOs of U.S. firms between 1980 and 2013 being underpriced on average by about 18 percent, implying that entrepreneurs on average leave money on the table. This 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 less shares from underpriced IPOs. Therefore, IPO underpricing is needed for retail investors to break even, otherwise they have no incentive to participate in the IPO market. Research has shown that while on average IPOs underperform other stocks in the three years after going public, there are 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 underperformed dramatically in the 1980s, the 1990s, and more recently. 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. In addition to the United States, these patterns have been present in Europe as well (Ritter, Signori, and Vismara 2013).
Finally, we have a good stock of information on the characteristics of firms following an IPO. Most 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 the years subsequent. Beyond a decline in productivity, IPO firms also on average 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 pursue innovation internally.
There are still many unsolved questions in the literature. Among them, researchers are unsure of why stock valuation does not settle at the correct price to reflect firms' "fundamental value" right after the announcement of M&As or IPOs, or why stock prices are misvalued in the first place. It is even more puzzling why it takes such a long time (three to five years) for the market to correct the misvaluation in the stock price. Additionally, much work remains to be done to further understand the role of IPOs in the innovation eco-system and their effects on employees and other stakeholders in the firm, and to better understand the effects of going public on firm operations. Finally, other remaining issues include:
While initial steps have been taken in these directions by some recent papers, much remains to be done, particularly if we want to think more broadly on how the IPO market could spur economic activity and growth.
It is widely documented by researchers that targets (i.e., the firms being acquired) gain from M&As. 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, however, do not fare so well; they experience negative stock returns in the same time window. Even though the negative return is not statistically significant, it is clear that acquirer firms do not gain from the deals. Several explanations have been proposed for this phenomenon. One explanation is the "hubris hypothesis," where acquirer managers are overconfident about their ability to manage the merged firm, overestimate the synergy from the M&A (Roll 1986), and then overpay for the target to complete the deal. Alternatively, the free cash flow hypothesis states that managers are reluctant to pay out free cash flows to shareholders (Jensen 1986), but instead engage in value-destroying M&As to increase the firm size because their private benefits of control increase with the size of the firm.
After the M&As, the acquirers fare even worse. For example, Mitchell and Stafford (2000) document that the three-year post-merge abnormal returns for acquiring firms from 1961 to 1993 is five percent, and the performance is even worse for stock-financed mergers. Other studies find similar patterns. 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 glamour 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).
These findings lead researchers to believe that M&As, especially stock-financed deals, are bad for acquirer shareholders on average, as managers in acquirer firms make these deals for their own private benefit at the cost of shareholders. A recent study provides a different view on these findings; 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 acquirer's stock price will go down, explaining the negative long-run stock return.
What researchers are unsure of is 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. The correction should take a relatively short time.
Another phenomenon regarding M&As that researchers are unsure of is merger waves. There have been several merger waves in the U.S. in the past few decades, and each wave was different from others. In the 1960s, there was a "conglomerate" wave, in which a firm acquires targets from other industries to form a large conglomerate. This merger wave is usually financed by stocks, and it coincides with high stock market valuations. In the 1980s, the U.S. experienced a different type of mergers characterized by hostile takeovers. The acquirers in this wave usually buy targets using cash raised through selling junk bonds. The merger wave in the late 1990s was characterized by stock-financed transactions and same-industry mergers. What drives different merger waves is still an area that needs further research.
Much of the existing academic literature has used a framework in which a successful entrepreneurial firm will go public at the appropriate stage in its life-cycle. Although this framework is appropriate for some firms, such as social networking company Facebook and restaurant chain Noodles, increasingly, firms are selling out in a trade sale rather than going public and remaining as an independent firm, so being acquired is now an important alternative to going public for most firms. Nonetheless, for the firms that do choose to go public, we have a good body of research on what that process looks like.
In other words, there are two issues: public versus private, and independent firm versus being part of a larger organization. Historically, the literature has assumed that being an independent firm was the optimal strategy for a successful company, but if both decisions are considered, going public is not necessarily an essential part of the life cycle of a successful startup.
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 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 (1962) and demonstrated empirically (see, for example, Brown, Fazzari, and Petersen 2009; Himmelberg and Petersen 1994; and Mulkay, Hall, and Mairesse 2001), R&D is likely to be more sensitive to financing constraints than other forms of investments as a result of information problems, skewed and uncertain returns, and the potentially scant collateral value of intangible assets.
IPOs come in waves. Hot-issue markets are characterized by high levels of initial returns with an average underpricing of 48.4 percent, and a large number of IPOs. In cold markets, IPO underpricing is low and the number of firms going public is small. Historically in the U.S., the average number of IPOs dropped from 310 per year between 1980 and 2000 to 103 per year between 2001 and 2013. A significant peak occurred during the Internet bubble period of 1999 to 2000, during which 803 companies went public in the U.S. during these two years alone, raising about $123 billion. Gao et al. (2013) document that the slowdown over the last decade since then has primarily affected the probability of smaller firms doing an IPO .
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, rose to 72 percent during the Internet bubble, then returned to 29 percent in 2001. Even in the resurgent IPO markets of 2013 and 2014, tech companies have been a low percentage of IPOs, with biotech company IPOs at an all-time high. By comparison, the hot-issue market of 1980 consisted of primarily natural-resource firms (Ritter 1984). While conventional wisdom may suggest that quality of firms may vary in periods of high issuance activity, not much evidence of that has been found (see for example, Helwege and Liang 2004 and Loughran and Ritter 2004).
April 2012 saw the passage of the JOBS Act 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) that might have potentially affected the probability of smaller firms staying away from the IPO market. Gao et al., however, suggest that the decline in the IPO market is driven by the change in the nature of the economy where 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 by themselves.
In Gao et al.'s "Where Have All the IPOs Gone?" (2013), the authors 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.
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; however, this often comes at the cost of losing control and dealing with the complexities of public market. The control issue is complicated. For firms that are buyout-backed or VC-backed, going public can actually give management more control.
A more complex question is when do firms IPO, and what characterizes those firms. The extant research on this question is deep, and the answers are many and varied. For example, Chemmanur and Fulghieri (1999) imply that larger and more capital-intensive firms with riskier cash flows, and those operating in industries characterized by a smaller extent of 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, thus implying that firms characterized by greater productivity, output growth, and capital expenditures are more likely to go public.
Chemmanur et al. (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 rations are more likely to go public, and mostly firms seem to do so to reduce the cost of credit. Lerner (1994) studies the biotech industry and finds that market-to-book rations indeed have a substantial effect on the decision to go public. While 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.
It is widely documented that IPOs are underpriced; i.e., the offer price is lower than the first-day trading price on average. 7,866 IPOs of U.S. firms between 1980 and 2013 were underpriced by about 18 percent on average, implying that entrepreneurs tend to 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 best established of these are the asymmetric information-based models, such as Welch (1989) and Chemmanur (1993), who assume that the issuer is better informed about its 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 so can avoid participating in overvalued IPOs. The resulting winner's curse experienced by uninformed investors has to be countered by deliberate underpricing, meaning IPO underpricing 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 to buy 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.
If IPO underpricing is excessive and the fees charged by underwriters are too high, these facts raise the question of how this can persist in spite of competition from many underwriters and the existence of sophisticated venture capital and private equity firms that back many of the companies going 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, so 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 probably win this deal even if there are many potential competing underwriters that would offer more attractive terms. Liu and Ritter 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, but instead distribute shares to limited partners starting six months after the IPO and fully exit within a few years.
Recent research complicates the 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 over 2000 IPOs from 1980 to 1997, IPOs are priced 14 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 has been 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 is a way through which underwriters extract information from institutional investors about 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 "low ball" 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 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 receive allocations of other hot IPOs have first-day returns that are 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 book building is used for pricing and allocating the shares. Book building is the procedure used in 99 percent of U.S. IPOs, and most 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 in IPOs.
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, affected 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 1995), productivity (Chemmanur et al. 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).
The inverted U-shaped pattern of total factor productivity (TFP) change that Chemmanur et al. (2010) find 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. Direct empirical evidence of this is provided by Bernstein (2015), who shows that the quality of internal innovation declines following the IPO and that 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.
Although IPOs underperform on average, in the long run, the underperformance is limited to companies with smaller annual sales at the time of the IPO (less than $60 million or so in terms of 2016 purchasing power), as shown in Ritter (2011). Furthermore, IPOs tend to be firms with high asset growth and low profitability, characteristics that are associated with low returns in general. The IPOs with low sales are especially likely to be money-losing firms.
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↩
One area where future research should concentrate is 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. What researchers are unsure of is why stock valuation does not come down more to reflect their "fundamental value" right after the announcement, or why stock prices are misvalued in the first place. As previously mentioned, it is even more puzzling why it takes such a long time (three to five years) for the market to correct the misvaluation in the stock price. Maybe future research will shed more light on these issues.
Future research should 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.
The literature has documented that going public seems to affect the real performance of firms. There are many related and interesting questions about what is it exactly that changes 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 as a result of the quarterly earnings, expected growth, and analysts' careful coverage. Understanding more thoroughly how such changes affect the decision-making within the firm seem to be a promising avenue for future research.
Other interesting questions relate to the role of IPO markets in the innovation eco-system more broadly. What is the impact of IPO markets on early stage financing and the tendency of entrepreneurs to start new businesses? How big is the effect? If such effects are substantial, the lack of much IPO activity over last decade may have substantial and real consequences beyond the availability of capital for growing companies. Better understanding recent changes in IPO markets is yet another interesting questions that have important policy implications.
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Mark Liu - Associate Professor of Finance, University of Kentucky, Contributor
Mahka Moeen - University of North Carolina, Contributor
Debarshi Nandy - Brandeis University, Contributor