Skip to main content
SpringerLink
Log in

The price of rapid exit in venture capital-backed IPOs

  • Research Article
  • Published:
Annals of Finance Aims and scope Submit manuscript

Abstract

This paper proposes an explanation for two empirical puzzles surrounding initial public offerings (IPOs). Firstly, it is well documented that IPO underpricing increases during “hot issue” periods. Secondly, venture capital (VC) backed IPOs are less underpriced than non-venture capital backed IPOs during normal periods of activity, but the reverse is true during hot issue periods: VC backed IPOs are more underpriced than non-VC backed ones. This paper shows that when IPOs are driven by the initial investor’s desire to exit from an existing investment in order to finance a new venture, both the value of the new venture and the value of the existing firm to be sold in the IPO drive the investor’s choice of price and fraction of shares sold in the IPO. When this is the case, the availability of attractive new ventures increases equilibrium underpricing, which is what we observe during hot issue periods. Moreover, I show that underpricing is affected by the severity of the moral hazard problem between an investor and the firm’s manager. In the presence of a moral hazard problem the degree of equilibrium underpricing is more sensitive to changes in the value of the new venture. This can explain why venture capitalists, who often finance firms with more severe moral hazard problems, underprice IPOs less in normal periods, but underprice more strongly during hot issue periods. Further empirical implications relating the fraction of shares sold and the degree of underpricing are presented.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

References

  • Admati A.R., Pfleiderer P. (1994) Robust financial contracting and the role of venture capitalists. J Financ 49, 371–402

    Article  Google Scholar 

  • Allen F., Faulhaber G.R. (1989) Signalling by underpricing in the ipo market. J Financ Econ 23, 303–323

    Article  Google Scholar 

  • Baker, M., Gompers, P.: Executive ownership and control in newly public firms: the role of venture capitalists, (1999) (in press)

  • Barry C., Muscarella C.J., Peavy J.W., Vestuypens M. (1990) The role of venture capital in the creation of public companies: evidence from the going public process. J Financ Econ 27, 447–471

    Article  Google Scholar 

  • Benveniste L.M., Spindt P.A. (1989) How investment bankers determine the offer price and allocation of new issues. J Financ Econ 24, 343–361

    Article  Google Scholar 

  • Benveniste L.M., Busaba W.Y., Wilhelm W.J. (2002) Information externalities and the role of underwriters in primary equity markets. J Financ Interm 11, 61–86

    Article  Google Scholar 

  • Berglöf F. (1994) A control theory of venture capital finance. J Law Econ Organ 10, 247–267

    Google Scholar 

  • Black B.S., Gilson R.J. (1998) Venture capital and the structure of capital markets: bank versus stock market. J Financ Econ 47, 243–277

    Article  Google Scholar 

  • Brau J., Fawcett S. (2006) Initial public offerings: an analysis of theory and practice. J Financ 61, 399–436

    Article  Google Scholar 

  • Brennan M.J. (1990) Latent assets. J Financ 45, 708–730

    Google Scholar 

  • Choe H., Masulis R., Nanda V. (1993) Common stock offerings across the business cycle: theory and evidence. J Empir Financ 1, 3–31

    Article  Google Scholar 

  • Cumming D.J., MacIntosh J.G. (2003) A cross-country comparison of full and partial venture capital exit strategies. J Bank Financ 27, 511–548

    Article  Google Scholar 

  • Dai, N.: The double exit puzzle: Venture capitalists and acquisitions following IPO (2005) (in press)

  • Engers M. (1987) Signalling with many signals. Econometrica 55, 663–674

    Article  Google Scholar 

  • Francis B.B., Hasan I. (2001) The underpricing of venture and non venture capital IPOs: an empirical investigation. J Financ Serv Res 19, 99–113

    Article  Google Scholar 

  • Franzke S.A. (2004) Underpricing of venture-backed and non venture-backed IPOs: Germany’s neuer markt. In: Giudici G., Roosenboom P. (eds) The rise and fall of Europe’s new stock markets. Oxford, Elsevier

    Google Scholar 

  • Garfinkel J.A. (1989) IPO underpricing, insider selling and subsequent equity offerings: is underpricing a signal of quality? Financ Manage. 22, 74–83

    Article  Google Scholar 

  • Giudici G., Roosenboom P. (2004) Pricing initial public offerings on ‘new’ European stock markets. In: Giudici G., Roosenboom P. (eds) The rise and fall of Europe’s new stock markets. Oxford, Elsevier

    Google Scholar 

  • Gladstone D. (1987) Venture capital handbook: new and revised. UK, Financial Times Prentice Hall

    Google Scholar 

  • Gompers, P.A.: Ownership and control in entrepreneurial firms: an examination of convertible securities in venture capital investment (1999) (in press)

  • Gompers P.A. (1995) Optimal investment, monitoring, and the staging of venture capital. J Financ 50, 1461–1489

    Article  Google Scholar 

  • Gompers A.P., Lerner J. (1999) The venture capital cycle. Cambridge, The MIT Press

    Google Scholar 

  • Grinblatt M., Hwang C.H. (1989) Signalling and the pricing of new issues. J Financ 44, 393–420

    Article  Google Scholar 

  • Hellmann, T.F.: IPOs, acquisitions and the use of convertible securities in venture capital. J Financ Econ (2006) (in press)

  • Helwege J., Liang N. (2004) Initial public offerings in hot and cold markets. J Financ Quant Anal 39, 541

    Article  Google Scholar 

  • Ibbotson R., Ritter J.R. (1995) Initial public offerings. In: Jarrow R.V.M., Ziemba W. (eds) Handbooks of operations research and management science. Amsterdam, North-Holland

    Google Scholar 

  • Jegadeesh N., Weinstein M., Welch I. (1993) An empirical investigation of ipo returns and subsequent equity offerings. J Financ Econ 34, 153–175

    Article  Google Scholar 

  • Jeng L.A., Wells P.C. (2000) The determinants of venture capital funding: evidence across countries. J Corp Financ Contract, Govern Organ 6, 241–289

    Google Scholar 

  • Jenkinson T., Ljungqvist A. (2001) Going public: the theory and evidence on how companies raise equity finance. Oxford, Oxford University Press

    Google Scholar 

  • Kaplan S., Stromberg P. (2003) Financial contracting theory meets the real world: An empirical analysis of venture capital contracts. Rev Econ Stud 70, 281–315

    Article  Google Scholar 

  • Lee P.M., Wahal S. (2004) Grandstanding, certification and the underpricing of venture capital backed IPOs. J Financ Econ 73, 375–407

    Article  Google Scholar 

  • Leland, H.E., Pyle, D.H.: Informational asymmetries, financial structure, and financial intermediation. J Financ 32, 371–387, Papers and Proceedings of the 35th Annual Meeting of the American Finance Association (1977)

  • Leone, A.J., Rock, S., Willenborg, M.: Disclosure of intended use of proceeds and underpricing in initial public offerings. In: Technical Report FR 03-07, Simon School of Business (2003)

  • Lewis, C.M., Ivanov, V.: The determinants of issue cycles for initial public offerings (2002) (in press)

  • Lin T.H., Smith R.L. (1998) Insider reputation and selling decisions: the unwinding of venture capital investments during equity IPOs. J Corp Financ 4, 241–263

    Article  Google Scholar 

  • Ljungqvist A.P., Habib M. (2001) Underpricing and entrepreneurial wealth losses in ipos: theory and evidence. Rev Financ Stud 14, 433–458

    Article  Google Scholar 

  • Ljungqvist A.P., Nanda V., Singh R. (2006) Hot markets, investor sentiment, and IPO pricing. J Bus 79, 1667–1703

    Article  Google Scholar 

  • Loughran T., Ritter J.R. (2002) Why don’t issuers get upset about leaving money on the table in IPOs. Rev Financ Stud 15, 413–443

    Article  Google Scholar 

  • Loughran T., Ritter J.R. (2004) Why has IPO underpricing changed over time?. Financ Manage 33, 5–37

    Google Scholar 

  • Lowry M. (2003) Why does IPO volume fluctuate so much?. J Financ Econ 67, 3–40

    Article  Google Scholar 

  • Lowry M., Schwert G.W. (2002) IPO market cycles: Bubbles or sequential learning?. J Financ 57, 1171–1201

    Article  Google Scholar 

  • Megginson W.L., Weiss K.A. (1991) Venture capitalist certification in initial public offerings. J Financ 46, 879–903

    Article  Google Scholar 

  • Michaely R., Shaw W.H. (1994) The pricing of initial public offerings: Tests of adverse-selection and signaling theories. Rev Financ Stud 7, 279–319

    Article  Google Scholar 

  • Milne F., Ritzberger K. (2001) Strategic pricing of equity issues. Econ Theory 20, 271–294

    Article  Google Scholar 

  • Pástor A, Veronesi P. (2005) Rational IPO waves. J Financ 60, 1713–1757

    Article  Google Scholar 

  • Quindlen R. (2000) Confessions of a venture capitalist: inside the high-stakes world of start-up financing. New York, Warner Books

    Google Scholar 

  • Quinzii M., Rochet J.-C. (1985) Multidimensional signalling. J Math Econ 14, 261–284

    Article  Google Scholar 

  • Rajan R., Servaes H. (1997) Analyst following of initial public offerings. J Financ 52, 507–529

    Article  Google Scholar 

  • Riley J.G. (1979) Informational equilibrium. Econometrica 47, 331–360

    Article  Google Scholar 

  • Ritter J.R. (1984) The hot issue market of 1980. J Bus 57, 215–240

    Article  Google Scholar 

  • Rydqvist C., Hogholm K. (1995) Going public in the ’80s. Eur Financ Manage 1, 287–315

    Article  Google Scholar 

  • Sahlman W. (1990) The structure and governance of venture capital organizations. J Financ Econ 27, 473–524

    Article  Google Scholar 

  • Salanié B. (1999) The economics of contracts: primer. Cambridge, MIT Press

    Google Scholar 

  • Smart S.B., Zutter C.J. (2003) Control as a motivation for underpricing: a comparison of dual-and single class IPOs. J Financ Econ 69, 85–110

    Article  Google Scholar 

  • Smith C. (1986) Investment banking and the capital acquisition process. J Financ Econ 15, 3–29

    Article  Google Scholar 

  • Stoughton N.M., Wong K.P., Zechner J. (2001) IPOs and product quality. J Bus 74, 375–408

    Article  Google Scholar 

  • Welch I. (1989) Seasoned offerings, imitation costs, and the underpricing of initial public offerings. J Financ 44, 421–449

    Article  Google Scholar 

  • Welch I., Ritter J. (2002) A review of IPO activity, pricing, and allocations. J Financ 57, 1795–1828

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Warwick Business School, Coventry, UK

    Silvia Rossetto

Authors
  1. Silvia Rossetto
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Silvia Rossetto.

Rights and permissions

Reprints and permissions

About this article

Cite this article

Rossetto, S. The price of rapid exit in venture capital-backed IPOs. Annals of Finance 4, 29–53 (2008). https://doi.org/10.1007/s10436-006-0065-8

Download citation

  • Received:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10436-006-0065-8

Keywords

JEL Classification Numbers

Search

Navigation