The aftermarket performance of small firm initial public offerings

Abstract

The dream of many entrepreneurs is to some day take his or her growing small firm public and, to thereby become the CEO of a publicly-traded corporation. Currently, entrepreneurs are continuing to utilize initial public offerings (IPOs), as a viable source of venture financing. IPOs also represent a viable mechanism for harvesting venture capital and entrepreneurial investments. The touted entrepreneurial benefits of taking a company public include the abilities to borrow additional funds; return to the public equity market; negotiate mergers without depleting cash; the potential for enhanced personal wealth and so forth. Investors in small firm public equity issues are often motivated by the potential for discovering another Apple Computer, or perhaps an IBM at the “ground floor.” This study empirically examines the aftermarket returns of small publicly-held firms that have issued initial public offerings. Aftermarket returns refers to stock returns immediately after a stock begins trading. The study specifically examines two questions. First, “Is there a positive risk-return relationship for small firm aftermarket returns, where higher firm risk will generate higher aftermarket return?” Second, “Will aftermarket returns show on industry effect, where certain industries will automatically generate higher returns?” Answers to these questions will affect the strategic financial alternatives available to entrepreneurs both before and after going public and, will also affect the decisions of investors interested in financing small public corporations. The research findings indicate that entrepreneurs planning to take younger firms public will probably not have available to them numerous subsequent financial alternatives, utilizing corporate stock, if the true aftermarket performance of their stock is taken into consideration. Likewise, investors in small firm public issues may also be disappointed in the aftermarket performance of younger firms. A positive risk-return relationship, where age was a proxy measure of risk, did not exist. This was true even though the initially quoted returns of these same younger firms may have been substantial. On the other hand, the aftermarket performance of older firms is typically favorable. Finally, the study suggests that neither entrepreneurs nor investors should bet solely on a particular industry categorization to “carry” their aftermarket stock performance. While certain industries indicated significant positive initial returns, aftermarket returns based on industry classification were generally not statistically significant. Investors should therefore always exercise firmspecific due diligence and research before investing in small firm public equity issues, since the variance of their aftermarket market returns tends to be large.