Debt Financing, Venture Capital, and Initial Public Offerings

Abstract

We examine the comparative roles of debt financing and venture capital in the performance of companies that go public. For a sample of more than 5,000 IPOs during the period 1980-2002, we find that firms with high debt financing tend to exhibit characteristics of lower valuation uncertainty and risk than firms that are backed by venture capital. We document a strong negative relation between debt financing and initial returns (or underpricing), after controlling for other factors affecting these returns. For the entire sample, one standard deviation change in leverage is associated with 7% lower underpricing. Our results are especially pronounced during periods with high valuation uncertainty. For example, during the 1999-2000 period, firms with high debt levels and without venture capitalist backing averaged 60% lower underpricing than firms with low use of debt financing but backed by venture capitalists. Our results confirm the theories of James and Wier (1990), who hypothesize that debt financing is associated with lower initial returns, and Ueda (2004) who hypothesizes about the comparative effects of banks and venture capitalists on IPO firms. Also consistent with Ueda's theory, we document that debt financing and venture capital tend to be substitutes. We also examine the comparative effects of debt financing and venture capital on the long-term performance of IPO firms. Overall, we find that high levels of debt financing are associated with negative aftermarket performance in the five years after the IPO, in contrast with the comparatively positive performance of venture capital-backed firms, after adjusting for market risk, size, and book-to-market effects. Brav and Gompers (1997) show that the negative long-term performance of IPOs is primarily associated with small firms that do not have venture capital backing. We find that firms with substantial debt financing tend to have especially low performance. Furthermore, we show that the firms characterized by Brav and Gompers as small (in market capitalization) and without venture capital are generally also firms with high debt financing. Thus, the characteristics of firms with extensive debt financing help to account for both their lower initial returns at the IPO, and their negative long-term performance following the IPO. While the underperformance of debt-backed firms demonstrates a statistically meaningful anomaly, it may suggest further need for incorporating the effect of debt in examining investment performance, as suggested recently by related results for non-IPO firms by Billett, Flannery, and Garfinkel (2005).