Entrepreneurial Finance Lecture 5

3 main categories of exits:

1)       Going public (via initial public offering = IPO)

2)       Acquisition

3)       Liquidation (Via shutting down firm)

IPOs and acquisitions are typically considered successful exits. Although less highlighted, most startups are shut down.

Distribution of startup Outcomes (in the US)

VC financed-firms have a 40% liquidation rate.

Non-VC financed firms have a 80% liquidation rate.

36% of VC financed firms go through acquisition.

1% of Non VC-financed firms go through acquisition.

16% of VC-financed firms go public, 0% of Non VC-financed firms go public.

What does it tell about Selection Skill of VCs?

About investing, VCs don’t make perfect predictions, but better than non-VC-investors in what they choose to invest -> lower failure + higher success rates. VCs good at avoiding total duds.

Characterizing exit types

IPO: shares are sold to public on stock market. Usually not an immediate cash exit. Subject to a back-up period before they can sell.

Acquisition: buyer buys all shares in company. Could be company or financial investor.

Liquidation: when things got sour, investors shut down company and sell underlying assets to various buyers, in exchange of (small) cash.

Exit types - Investors’ preference

IPO most favorite exit route by VC -> most profitable. But there is selection: only high-flyers can go public.

 Acquisition used to exit both successful and unsuccessful investments. So could a corporate buyer be willing to pay more than liquidation value for a company with interesting technology.

Liquidation rather private than public, because of reputation, legal costs and to “fail fast”.

-            Formal bankruptcy is rare: startups’ value diminish quickly, which mainly consists of intangible assets (team/IP). Court process is lengthy, making court process value-destructive.

-             Can unlock VCs assets and attention from bad projects and redeploy somewhere else.

Which type of exit is most prominent in US?

(Buyout = type of Acquisition)

Bij median deal value -> IPOs meest voorkomend
Bij deal count: Acquisitions (buyout type of acquisition)

Why did firms go public?

Raise capital from public equity markets

-            Debt becoming too expensive

-            Private equity (like VC) has run out

Achieve liquidity

-            Allow pre-IPO owners to cash out

-            Broaden ownership base

-            Stocks can be used for future acquisitions

Enhance reputation of company

-            Attract attention of analysts

-            Establish market price/valuation

-            Signal stability to customers and suppliers.

Costs of going public

Fundamental changes to firm environment

o   Public firms subject to disclosure requirements & scrutiny (Loss of proprietary information to competitors & meeting disclosure rules compliance is costly (e.g litigation threats))

 

o   Increased, dispersed shareholder base (Shareholders vote with their feet (by selling the shares) & unlike VCs who assist managers)

 

Direct costs -> Hiring an underwriter, auditor, legal advisors, printing costs

Indirect costs -> Underpricing: some money left on table

IPO pricing process: Role of the Underwriter

To go public, the firm provides an issue price.

-            Issue price: price at which shares will be initially sold to interested investors.

-            Set by the underwriter (investment bank) in consultation with the firm.

“Firm Commitment” underwriting (Standard Model):

-            The underwriter guarantees buying all shares from the company at a discount and reselling them to investors.

-            This transfers the risk of unsold shares (“inventory risk”) from the company to the bank.

Pricing mechanisms

(1)Book building: Most common worldwide.

Organized by the underwriter.

1)       Prepare prospectus & establish pricing range.

2)       Roadshow to institutional investors; collect info about investor demand

3)       Solicit bids from institutional investors, building an “order book”

4)       Set a final price. Allocates shares to investors (typically discretionary)

(2)Fixed price offerings: one price is agreed for all interested parties.

·       Simplest mechanism

·       Price is set in advance and non-negotiable

(3)Auction: interested parties submit bids that they want to buy at.

·       More market-driven approach; can help reduce underpricing

(4)Hybrid: combine 2+ mechanisms (e.g., Airbnb)

Empirical irregularities of IPO

1)       IPO markets very cyclical (hot issue markets)

2)       First day underpricing

3)       Long run under-performance

Underpricing puzzle

Very often, stock price goes up strongly in days after the IPO.

-            That is, the market price > issue price (“Underpricing”)

It is bad news to issuing firm, because the issue price was too low, so the firm left money on the table’. For the investor who were allocated the new shares it is good news, because they can directly make profit by getting the shares for under the market price and now selling them fore more.

Despite money left, it is a repeating pattern (puzzle).

Underpricing over time (In the U.S.)

• Rode balken (Aantal IPO's): De IPO-markt is sterk cyclisch. Er zijn duidelijke periodes met extreem veel beursgangen (zogeheten "hot issue markets"), zoals tijdens de internetzeepbel rond 1996-2000 en de tech-boom in 2021.

• Zwarte lijn (Gemiddeld rendement op de eerste dag): Dit geeft de mate van underpricing (onderprijzing) aan. Als aandelen op de eerste handelsdag hard stijgen, waren ze vooraf eigenlijk te goedkoop aangeboden. Deze lijn fluctueert enorm over de tijd.

Opvallende trends

• De internetzeepbel (1999-2000): Dit is het meest extreme punt in de grafiek. Het aantal IPO's was weliswaar hoog, maar vooral de zwarte lijn schoot naar een recordhoogte van meer dan 70% rendement op de eerste dag.

• De piek in 2021: Hier is een herhaling van het patroon te zien. Er was een enorme piek in het aantal beursgangen (rode balk), gecombineerd met een sterke stijging van het eerste-dagsrendement (zwarte lijn) tot bijna 50%.

• Rustige periodes: Na grote crashes (zoals na 2001 en na de financiële crisis in 2008) daalden zowel het aantal IPO's als de eerste-dagsrendementen naar een historisch dieptepunt.

What explains underpricing puzzle?

Asymmetric Information Models (The Dominant Theory)

Assumption: Information friction exists between parties.

Issuer vs. Underwriter; Issuer vs. Investor

Informed vs. Uninformed Investors: The “Winner’s Curse” (we will focus on Rock’s 1986 model here)

Institutional theories

Litigation: Underpricing acts as “insurance” against future lawsuits (keeping investors happy)

Bank incentives: Facilitates “spinning” (allocating shares to executives) and price stabilization.

Control theories

Strategic ownership: Underpricing creates excess demand, allowing issuers to fragment ownership (many small shareholders) and reduce intervention by large blockholders.

Behavioral Theories

Irrationality: Presence of “sentiment” investors bidding prices beyond fundamental value.

Information-based Explanations (the Winner’s curse)

Key idea: Info asymmetry within investors.

Some investors better informed than others and so can avoid participating in overvalued IPOs.

Uninformed investors fear that they will only be allotted shares in bad IPOs -> “Winner’s Curse”.

The winner’s curse experienced by uninformed investors has to be countered by deliberate underpricing.

-            Otherwise, they would never participate and stocks fail to sell.

Institutional Theories Agency Conflicts

The mechanism: “Buying favors” with underpriced shares.

-            Spinning: Underwriters offer shares in hot IPOs to executives in companies whose business the bank is looking to attract. Largely banned after 2003 as it is seen as a form of bribery

-            Flipping: Investors allocated shares in the IPO sell them on the first day of trading at a significant profit. A way for investment banks to reward their institutional clients. Legal but regulated. Banks can penalize investors who flip too frequently (e.g. by excluding them from future IPOs)

The economic trade-off

-            Underwriting fees are typically  proportional to IPO proceeds

-            Countervailing incentive: Underpricing reduces the deal size and lowers the bank’s fee

-            Conclusion: Banks only underprice if the private benefits (future business) outweigh the lost fees.

Can info-based theories explain entire variation? Wouldn’t behavioral theories explain better in some periods?

Hot markets (like the dotcom-bubble 1999-2000) typically show higher underpricing.

Investors are more optimistic and willing to pay higher premiums.

Underpricing across countries vs theories

Asymmetric info theories

• Transparency & accounting standards: in mature markets (vs. less mature ones) info friction is lower → Winner’s Curse is smaller.

Institutional theories

• The US: despite mature market, highly litigious culture. Issuers intentionally underprice to “insure” against lawsuits.

More research is needed!

• Food for thought: even within Europe, large variation. Norway<Netherlands<Germany.

Quiet period

During the first 25 days after the IPO the firm and its underwriters have to remain silent about the firm’s financial prospects

Purpose: Allow market to find natural price level.

-            Prevent insiders from “hyping up” the price

-            Ensure fair information dissemination and protect investors

After 25 days underwriters release their (usually favorable) reports about the firm.

On average stock price rises at the end of the quiet period.

Lock-up period

Underwrites require that initial pre-IPO shareholders do not sell their stock for a pre-determined period (usually 180 days).

Why it exists:

-            Keep incentives aligned (prevent insiders from flipping)

-            Prevent downward pressure on stock prices if a large number of shares are sold at once

Locked up investors sell at the expiration of the lock-up period.

Stock price drops after the expiration of the lock-up period.

Long-run IPO underperformance evidence

Still holds now, while raw returns go up, IPOs underperform relative to benchmarks. IPO stocks underperform the market in the first 3 to 5 years after the IPO.

Long-run IPO underperformance, why?

Such underperformance is difficult to square with rational investors.

-            No rational investors would buy IPO stocks, only to lose money.

Possible explanations (behavioral):

Clientele effects: only optimistic/overconfident investors buy at IPO (everyone thinks they found the next Tesla), but beliefs converge when more info is released about the firm.

Window of opportunity: Valuations of IPOs are subject to fads, so issuers try to go public in hot markets (when investors tend to become optimistic, e.g. dot-com bubble)

Empirical pattern on IPO underperformance: driven by small, non-VC-backed offerings

-            Such small, non-prominent new companies could be more prone to market sentiment.

Long-run performance of vc-backed IPOs

The classic view: VCs add value

Brav & Gompers (1997): VC backed IPOs show significantly less underperformance than non-VC-backed ones.  Why? Theoretical explanations:

-            Certification hypothesis(Megginson & Weiss, 1991): VCs put their reputation on the line. They are a repeat player, hence underperforming IPOs lead to reputational penalties in future.

-            Active monitoring: VCs implement professional governance and management before the IPO.

Modern reality: The gap is shrinking

Recent data (Ritter, 2025) indicates the performance advantage of VC-backed firms has diminished over time.

Why has it shrunk? The “Staying private” effect

Promising startups stay private much longer (10+ years) due to abundant private capital.

Growth capture: The phase of explosive growth occurs while the firm is still private.

Result: VCs and private equity capture the high returns; public investors receive mature, stable firms with lower growth rates.

Criticisms of IPO mechanisms (Book building)

Note: these are distinct from the general (costs of going public)

1.       Agency conflicts and pricing inefficiencies

-            Underpricing: wealth transfer from issuers (to favored clients)

-            Potential for abuse: Conflicts of interest such as spinning

-            High fees: Concentration of underwriters (oligopoly) maintains high fees

2.       Allocation and Fairness issues

-            Lack of transparency: Opaque book-building process where allocation is fully discretionary

-            Lacks of fairness: Shares are allocated based on banking relationships rater than the highest bid.

-            Retail exclusion: The general investing public is largely excluded from the initial allocation

3.       Market power imbalances

-            Institutional dominance: Large investors have disproportionate influence on price setting

-            Underwriter power: Investment banks control the ‘gate’ to the public markets.

An alternative: Open IPO (Dutch auction)

-            Dutch auction used to discover market price

-            Offering listed online-accessible to retail and institutional investors

-            Investors bid for shares

-            Bids collected from highest price down, until you get enough shares for offering

-            Lowest price that clears the offering is the clearing price

-            All investors buy at price set by issuer, regardless of their bid

-            Oversubscription: allocation by price, and by time priority

Low adoption of OPEN IPO and alternatives

Examples: Google (2004) and Robinhood (2021)

Low adoption: has not become mainstream due to complexity and resistance from underwriters & institutional investors. Modern alternatives: new methods to avoid traditional IPO frictions include:

1)       Direct listings: company simply lists its existing shares on exchange. No new capital is raised, no underwriters set the price. Why used? -> The market finds the price immediately -> no underpricing.

2)       SPACs (special purpose acquisition companies): blank check company created by sponsor that goes public to raise capital and then find a non-listed operating company to merge with, a process that takes the company public. Why used -> speed to market.

Summing up

Exit hierarchy:  IPOs remain the preferred and most profitable route for VCs, with acquisitions serving as the primary alternative for later-stage exits. However, liquidations/shutdowns are the most common outcome.

The underpricing puzzle: Significant first-day returns (“Money left on the table) are partly a rational response to information asymmetry (The winner’s curse) and agency costs.

Long-run IPO Underperformance : Despite initial hype, IPOs frequently suffer from relative to market benchmarks.

Structural Frictions: Traditional book-building is prone to conflicts (e.g., spinning), leading to interest in alternatives like Open IPOs and Direct Listings.