Debt financing, venture capital, and the performance of initial public offerings☆
Introduction
We examine the roles of two providers of intermediated capital, venture capitalists (VC) and lenders, on the characteristics of the initial public offerings (IPO) firms, their initial returns (or underpricing), and their long-term performance following the IPO. While a number of IPO studies examine the effects of VC backing on the initial returns and long-run performance of IPOs, few examine the role of debt financing on the process of going public, and to our knowledge, none empirically examine the comparative roles and effects of debt financing versus venture capital in this process.
Using a sample of more than 6000 IPOs during 1980–2012, we provide three main results that extend the literature. First, we show that the characteristics of firms with high levels of debt financing are consistent with less uncertainty about firm value than those backed primarily by VC, and those characteristics generally support the theoretical predictions of James and Wier, 1990, Ueda, 2004, and Winton and Yerramilli (2008). We also provide evidence that debt financing and VC backing are substitutes, on average. However, this relationship is more complex: we show that VC and debt interact in more nuanced ways, and play complementary roles in certain cases (i.e., some firms have both VC backing and high debt use, similarly to the positive associations between the existence of VC and bank relationships documented by Gonzalez and James, 2007, and some firms have neither VC backing nor debt).
Second, we find that debt backing is associated with lower underpricing, with the effect especially pronounced in periods of high uncertainty. For the full period of our sample, firms in the highest quartile of debt financing averaged 14.1% initial day returns, while those in the lowest debt quartile averaged 22.9%. Our results complement and extend the finding of James and Wier (1990) who find lower underpricing for firms with bank or other private lending relationships during 1980–1983, and Schenone (2004), who reports negative association between debt and initial day returns for a narrow subset of IPOs whose underwriters were also the firms’ bankers during 1998–2000 (the peak of the Internet “bubble”), and whose debt is reported by DealScan, which eliminates a large set of smaller firms. In contrast, our study covers a very long period with varied market conditions (1980–2012), a large number of firms, and a very general, representative sample, that extends the findings from the shorter time periods studies by Schenone or James and Wier. On the other hand, this approach restricts our ability to identify the sources of debt only to information from existing databases such as Compustat, SDC and Dealscan, which limits our inferences on the effect of the identity of various lenders on the IPO process.
Our results hold when we control for the endogeneity related to the selection of VC or debt financing. The economics of the firm determines its use of VC or debt, and when the firm goes public that is realized in market valuation. The results show that the VC/debt choice is a strong signal of underlying firm characteristics and quality which investors pick up on.
Our third contribution is examining the comparative effects of debt financing and VC on the long-term performance of IPO firms. We find that long-term performance is monotonically decreasing by debt quartiles (controlling for risk factors), and that VC-backed firms outperform non-VC backed firms, on average. Furthermore, we find that the underperforming firms, characterized by Brav and Gompers (1997) as small (in market capitalization) and without VC, are frequently also firms with high level of debt financing. We also explore the interaction of VC backing and debt, and find that firms with high debt use and no VC backing perform particularly poorly compared to firms with VC backing (especially those with high VC reputation) and low levels of debt financing. We provide some additional evidence that firms with more reputable VCs tend to perform better.
Lenders and venture capitalists tend to examine carefully the risk associated with firms to which they make loans or equity investments. Unlike venture capitalists, the lenders do not generally share in the upside in equity value from the companies they finance, and so their tendency is to provide backing to firms with characteristics that make the lending relatively safe. Accordingly, we would expect firms with high levels of debt financing to have predicable cash flows, to show less volatility, and to be comparatively easier to value. These characteristics tend to be associated with less valuation uncertainty and, therefore, less underpricing at the IPO stage (see, for example, Rock, 1986). Those same characteristics may be associated with lower upside potential in equity value and hence lower long-term equity performance on average, in contrast with VC-backed IPO firms that perform better in the long-run, on average. Our empirical results are consistent with both the initial offer performance and aftermarket performance associated with the characteristics of major borrowers.
The remainder of the paper proceeds as follows: Section two provides a discussion of the theories and prior evidence of debt financing and VC for firms that are going public and for their performance following their IPO. Section three describes the data. Section four provides results on debt financing and the performance of debt-backed firms at the IPO stage. Section five provides results on the long-term performance of debt-backed and VC-backed firms. Section six provides a summary of the main results of the paper and the conclusions derived from those results.
Section snippets
Debt financing and venture capital: Theory and empirical hypotheses
When companies issue common stock in their IPOs, there is uncertainty on the part of the market about the value of the company. There may also be substantial information asymmetry between the firm and the market because of the limited disclosure that private firms are subject to and because of their lack of an established reputation in the public debt and equity markets. Lenders and venture capitalists overcome this difficulty by screening and monitoring the companies in which they invest. In
Data
The initial list of IPOs is provided by Jay Ritter as used in Ritter (2014). The sample contains 7700 IPOs of common stock in the US during the period 1980–2012. The list contains data on offer dates, firm identities, firm founding dates, an indicator of VC backing, and a variable indicating whether the firm was Internet-related. Some of the firm founding dates were collected by Laura Field and were used in Field and Karpoff (2002). We match the IPOs with firm and deal characteristics from
The effect of borrowing and VC backing on IPO underpricing
Table 5 provides regression results for the effect of debt and VC on initial returns, or underpricing. We control for characteristics of IPO firms that have been previously shown to be related to underpricing such as firm total assets, IPO proceeds, whether the firm is Internet-related, firm age, and the quality of the lead underwriter (measured by their Carter–Manaster ranks). We also include dummy variables for the periods 1990–1998 (“nineties”), 1999–2000 (the Internet “bubble”), 2001–2007
Debt financing, venture capital, and the aftermarket performance of IPOs
Brav and Gompers (1997) demonstrate that VC-backed IPO firms tend not to underperform, in general, in contrast to the underperformance results documented first by Ritter (1991). Chan et al. (2008) find positive abnormal performance for VC-backed IPOs, and Krishnan et al. (2011) find that VC-backed IPOs outperform non-VC backed IPOs.
Brav and Gompers find that small firms (in terms of market capitalization of equity) without VC backing are the principal negative aftermarket performers. In light
Summary and conclusions
We examine the comparative roles of debt financing and venture capital (VC) in providing capital for companies that go public, and the initial and long-term performance of those companies. We find that firms with high debt financing tend to be quite different than firms that are backed by VC, and the differences are consistent with the desire of lenders to protect the downside of their investments, in contrast with the venture capitalists striving to hit a “home run.” We find that companies
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The authors are grateful to Jay Ritter for providing data on initial public offerings. Some of Ritter’s data was developed by Laura Field. We are grateful to John Bizjak, Stan Block, Jack Cooney, James Cotter, Terry Dielman, Phil English, Jack He, Jan Jindra, Shane Johnson, Swaminath Kalpathy, Pete Locke, Antonio Macias, Steve Mann, David Marcus, Kristi Minnick, Paul Schultz, Hermann Tribukait, Jun Yang, and especially Vladimir Ivanov, Victoria Ivashina, and Tim Loughran for their helpful comments. We also are grateful to participants in the 2009 Midwest Finance Association, 2006 Frontiers of Finance Conference, 2006 FMA Meeting, 2006 FMA European Meeting, 2006 FIRS Conference, and seminar participants at American University, Auburn University, and University of Wyoming. We also appreciate the research assistance of Stefan Wolf. Professor Mihov acknowledges research funding from the Charles Tandy American Enterprise Center, the Luther King Capital Management Center for Financial Studies, and the Beasley Fellowship in Finance.