Strategy and IPO Market Selection: Implications for the Entrepreneurial Firm (1997)

A number of causes have commonly been identified as central to small firm failure, including management inadequacy and poor access to distribution channels. However, one of the principal causes of new firm failure is the lack of financial resources (Bruno, Leidecker, and Harder 1986). Therefore, if new small firms can gain better access to financial resources, the chance of their ultimate success will improve. An entrepreneurial firm's cash needs are particularly acute as its growth increases. One of the principal means by which a small firm can generate mezzanine capital for a major expansion or product development is through an initial issuance of stock to the public. However, many decisions about when to pursue an initial public offering (IPO) of stock appear to be driven principally by the prospect of an infusion of immediate cash to the firm rather than strategic analysis (Hare 1994). The decision regarding the IPO should incorporate not only the ability of the firm to pursue that activity, but also a strategic evaluation of how to maximize the firm's value. For example, entrepreneurs may not be incorporating the potential impact of of stock into their IPO decision-making. Underpricing occurs when the offering price for stock is below the price for which the stock trades subsequently in the immediate after-market (Aggarwal and Rivoli 1990; Beatty and Ritter 1986; Block and Stanley 1980; Brandi 1987; Chalk and Peavy 1987; Ibbotson and Jaffe 1975; Ibbotson, Sindelar and Ritter 1988; Logue 1973; McDonald and Fisher 1972; Neuberger and La Chapelle 1983; Reilly 1977; Ritter 1984; Ritter 1991; and others). To illustrate, in November 1993 Boston Chicken had an IPO at $20 per share. The very next day, the stock was trading at $48.50, an increase of 143 percent in the stock's value. The increase of $28.50 per share represents a loss of potential IPO benefits to the entrepreneurial firm. The increase in stock value in the after-market benefits the investor, not the firm. Thus, if Boston Chicken had pursued its IPO in another manner, waiting and meeting the requirements of the NYSE, it is possible that the benefits to the company may have far outweighed the costs due to the delay. The average underpricing of IPO stocks has been shown to be as high as 35 percent (McDonald and Fisher 1972). The effect on the firm of such underpricing is the denial of the full benefits of the IPO. The missed opportunity to obtain the full resources of the IPO may inhibit the future growth of the firm. The potential for reducing underpricing should be incorporated into the IPO decision-making process. Prior research on underpricing has typically occurred in the finance literature and has examined either a composite of initial public offerings (IPOs) from various markets or focused solely on the National Association of Securities Dealers Automated Quotation (NASDAQ) segment of the over-the-counter (OTC) market. However, Affleck-Graves et al. (1993) and Prasad (1995) suggest that the trading system has an impact on the underpricing behavior of IPOs. Because each stock exchange has different listing requirements, each exchange can be expected to present different underpricing risks to the firm. Once this risk is understood, the entrepreneur can then incorporate that risk into an evaluation of when and where to pursue an IPO. Underpricing indicates a lost opportunity to the business since the funds actually received by the firm are governed by the offering price for the issue. The higher the offering price, the greater will be the amount of funds received for a given quantity of shares issued. This aspect of IPOs has not received attention in prior research. This article expands on this topic by specifically investigating the offering prices as well as the impact of IPO underpricing of small firms on two of the major markets available to a firm: the NASDAQ segment of the OTC market and the NYSE. The impact of underpricing and the listing requirements of each market, from the perspective of the small firm, is discussed in the next section. …