top of page
  • Ruhi Desai

Catalysts of Market Entry: Exploring Optimal Timing and Motivations Behind IPOs

Introduction

Entrepreneurs contemplate various reasons when considering the pursuit of an Initial Public Offering (IPO), with the primary impetus often tied to issuing stocks to fund potential investment avenues. However, this singular motivation doesn't stand as the exclusive rationale behind opting for an IPO, given that alternative avenues such as bank loans or private equity placements could feasibly serve the same purpose. It's interesting to note that, despite the tendency to use IPOs for funding, there is a discernible trend that firms' investments tend to decline after an IPO (Pagano et al., 1998). This fascinating finding frequently inspires more research into the actual effectiveness of initial public offerings (IPOs) as a strategy for supporting ongoing investment growth.

Academic studies highlight the benefits of raising primary capital through the IPO process, especially when the issue is subscribed to by a diverse pool of investors. A diverse group of investors is said to boost the perceived valuation of the new entity and place a higher stock value in comparison to an undiversified investor base. Further, IPOs do invite greater scrutiny and monitoring from regulatory bodies, government agencies, and other external stakeholders. This external monitoring should improve a company's overall worth due to the increased degree of accountability and compliance.

IPO prices are often less than their closing price on the first day of the market. This subject of underpricing is arguably the most extensively researched in the IPO literature. We discover that CFOs have a fair understanding of the anticipated degree of underpricing. According to them, the main purpose of underpricing is to make up for the risk that investors assumed when they made their IPO investments. According to CFOs, underwriters' ambition to win over institutional investors' confidence is the second-biggest factor in underpricing (Brau & Fawcett, 2006).

According to signalling theory, the most encouraging signal in the IPO process, in the opinion of CFOs, particularly those of large companies, is excellent historical results. The second-strongest favourable indication is working with a renowned investment banker, and the third-strongest positive signal is deciding to enter a lengthy lockup. Selling insider shares, issuing units, and selling a sizable chunk of the company are all seen as warning signs. In this article, we will analyze the optimal conditions for the timing of IPOs as well as the motivations for going public.

 

Going Public

There is a dearth of empirical studies on the reasons behind corporate IPOs. Pagano et al. (1998) use a proprietary database of private Italian enterprises and compare it with public Italian firms to directly test for characteristics that influence a firm's decision to go public. Brau et al. (2003) take a less direct approach and compares private companies that decide to be bought by a public company and companies that decide to execute an IPO.

According to academic theory, there are multiple motivations for a company to go public. First, the cost of capital. Companies go public when they can minimize their cost of capital through external equity, thereby enhancing their value. Second, insiders can profit from initial public offerings (IPOs) by cashing out or using the opportunity to sell their shares for a profit.  IPO allows VCs to leave and presents an attractive harvest plan (Black & Gilson, 1998). Third, takeover activity might be aided by IPOs. According to Zingales (1995), an initial public offering (IPO) might be the first step toward a firm being acquired at a competitive price. IPOs could be significant since they grant a company publicly traded shares that can be used as "currency" to acquire other businesses or to be bought through a stock transaction. Lastly, Bradley et al. (2003) demonstrate how, following an IPO, analyst recommendations are frequently skewed upward. Thus, a company may be encouraged to undertake an IPO for positive analyst coverage.

IPO Timing

IPOs frequently occur in discrete waves, impacted by several theoretical models that explain why these occurrences tend to occur in groups at particular periods (Alti, 2005). One such theoretical topic is managerial methods designed to profit from favourable situations, especially when bullish market trends are present and favourable stock prices are dominant. In this paradigm, different empirical indicators play a crucial role in determining whether initial public offerings (IPOs) are viable in bull markets (hot IPO period). A bullish market phase can be identified by tangible indicators such as current general market conditions, industry-specific conditions, expectations for future market trajectories, industry conditions forecast, and even past market performance (Ritter, 1984).

The perceived desirability of the IPO market has a significant impact on when IPOs occur. One viewpoint emphasises the significance of recent first-day stock performance of firms that are just becoming public. This opinion holds that other businesses thinking about making a similar move may decide to take a different course entirely based on the success or failure of these initial public offerings. On the other hand, a different perspective contends that businesses want to go public when there is a favourable market environment and other respectable and prospective companies are being issued (Brau & Fawcett, 2006).

Furthermore, smaller businesses show a greater dependence on the performance of larger, more established companies going public as a predictor of advantageous timing. This inclination may arise from a desire to associate themselves with the accomplishments and legitimacy of these well-established organizations, with the intention of using the affiliation to enhance their own visibility in the marketplace. Essentially, these complex insights draw attention to the complex interactions between market dynamics, the necessity for outside capital, and the power of established firms in the IPO space.

The second element influencing the timing of initial public offerings (IPOs) is the improved managerial understanding of particular time-related factors, especially when venture capitalists (VCs) play a significant role in the IPO process. Belghitar & Dixon (2012) studied the positive role played by venture capitalists in the IPO process. Their increased impact might be ascribed to the managerial know-how and proficiency introduced by venture investors. Their participation gives businesses a better grasp of the several temporal aspects that are crucial to the IPO schedule. Consequently, these companies exhibit a more accurate alignment with advantageous market circumstances and well-planned timing for their initial public offerings.

Conversely, the third element focuses on an important finding about how ownership structure affects when an IPO occurs. More specifically, as larger firms traverse the IPO process, CFOs become less concerned with time issues. This decrease in importance suggests that CFOs at larger organizations are more likely to value quick profits above careful consideration when entering a market. (Brau & Fawcett, 2006).

The different ways that larger corporations and VC-backed companies think and approach the IPO process help to explain how different weights are given to time-related considerations. While the priority of CFOs in larger organizations tends to be more focused on precise market timing, the presence of venture investors greatly enhances managerial expertise and attention to timing factors.

Conclusion

There are several factors to consider when a firm decides to go public, beyond just lowering financing expenses. Sometimes, the main goal may be to create shares that are publicly traded and designated for potential future acquisitions. The company's goals in going public include lowering the cost of funding, enabling insider profit, supporting acquisition efforts, and gaining favorable analyst coverage. The performance of other companies going public, industry conditions, and market dynamics all have an impact on when to announce an initial public offering. Smaller companies, especially those with venture capitalist support, have a better understanding of timing and time, better timing their IPOs to coincide with advantageous market conditions. Larger companies, on the other hand, might prioritize market timing but also show a preference for speedier earnings over exact timing. Companies navigating the complicated world of initial public offerings must comprehend these complex dynamics. 

 

References


  1. Alti, A. (2005). IPO Market Timing. The Review of Financial Studies, 18(3), 1105–1138.

  2. Belghitar, Y., & Dixon, R. (2012). Do venture capitalists reduce underpricing and underperformance of IPOs? Applied Financial Economics, 22(1), 33-44.

  3. Black, B. S., & Gilson, R. J. (1998). Venture capital and the structure of capital markets: banks versus stock markets. Journal of Financial Economics, 47(3), 243-277.

  4. Bradley, D. J., Jordan, B. D., & Ritter, J. R. (2003). The Quiet Period Goes out with a Bang. The Journal of Finance, 58(1), 1-36.

  5. Brau, J. C., & Fawcett, S. E. (2006). Initial Public Offerings: An Analysis of Theory and Practice. The Journal of Finance, 61(1), 399-436.

  6. Brau, J., Francis, B., & Kohers, N. (2003). The Choice of IPO versus Takeover: Empirical Evidence. The Journal of Business, 76(4), 583-612.

  7. Pagano, M., Panetta, F., & Zingales, L. (1998). Why Do Companies Go Public? An Empirical Analysis. The Journal of Finance, 53(1), 27-64.

  8. Ritter, J. R. (1984). The "Hot Issue" Market of 1980. The Journal of Business, 57(2), 215-240.

  9. Zingales, L. (1995). Insider Ownership and the Decision to Go Public. The Review of Economic Studies, 62(3), 425-448.

35 views0 comments

Comments


bottom of page