The performance of initial public offerings in the biotechnology industry

ABSTRACT This study examines the underpricing and aftermarket performance of the emerging industry of biotechnology. Results from a sample of IPOs of 1987 to 1994 exhibit a mean first-day return of 1.8 percent compared to a 1.6 percent return on the NYSE Index. Furthermore, the biotech firms significantly underperformed the NASDAQ and NYSE indexes over a two-year period after going public. INTRODUCTION Among the primary areas of interest to researchers in entrepreneurship is the performance of firms' common stock when initially sold to public investors. These initial public offerings (IPOs) of firms' common stock can be made by newly formed companies or by established companies selling their securities to the public for the first time, and these companies may be in newly emerging industries or in industries with a relatively long history. Although previous research has centered principally on the general population of IPOs, this study focuses on IPOs of an emerging industry, those of companies involved in the use of biotechnology. The specific purpose of this paper is to examine the pricing of biotech IPOs. Previous empirical research of the pricing of IPOs has found that on average there is significant underpricing (see, for example, studies by Block & Stanley, 1980; Ibbotson, 1975; Levis, 1993; Logue, 1973; McDonald & Fisher, 1972; Neuberger & LaChapelle, 1983; Reilly & Hatfield, 1969; Ritter, 1991. While most of the underpricing is in the initial offer, some studies have also found underpricing to continue for a short time in the aftermarket. The purpose of this paper is to examine issues related to whether IPO price performance is industry-specific. We look for EPO underpricing in the biotech industry and test for a relationship between first-day and longer-term returns. In addition, we attempt to identify a relationship between price performance during hot versus cold markets. These issues are important to entrepreneurship scholars and practitioners for several reasons. First, entrepreneurs who are taking firms public should be aware of patterns that may occur in the aftermarket. For instance, Schiller (1990) hypothesized that equity markets in general and the EPO market in particular are subject to fads that affect market prices and hence the cost of going public. If entrepreneurs understand pricing patterns in the market, they may be able to minimize any negative aspects by taking responsive action, such as adjusting their capital structure. Second, the cost of external equity capital for companies going public depends not only upon the transaction costs incurred in initially going public but also the returns that investors receive in the aftermarket (Ritter, 1991). In essence, the cost of external equity will be higher for firms with lower returns in the aftermarket. Third, a high volume of biotech IPOs associated with poor long-run performance would indicate that entrepreneurs are successfully taking advantage of windows of opportunity (Ritter, 1991). The selection of the biotech industry rather than other industries for constructing the sample has particular relevance for entrepreneurs. Entrepreneurial ventures are often companies that are relatively young, are introducing or developing new products or services previously untested in the market, and whose stocks are viewed as risky but with high return potential. Firms in the biotech industry typically have these same characteristics, often to the extreme. Because previous studies examining IPOs in general include many firms in their sample that may not have these characteristics, this study should be of special interest to entrepreneurs. The first part of the paper gives a short review of the performance of IPOs. The next section describes the sample of IPOs used in the study and the methodology used to examine the short-run and long-run performance. The third part of the paper presents cross-sectional and time-series evidence on initial and aftermarket performance. …