IPOs and The Growth of Firms
by Gian Luca Clementi
Recent years have witnessed a rapid accumulation of empirical evidence documenting firm dynamics before and after the Initial Public Offering of equity. A particularly striking finding is that operating performance, as measured by either Operating Returns on Assets or Cash Flows over book value of assets, peaks in the period before the offering, worsens on impact at the IPO date, and keeps on declining for a few more years. In this paper we construct a simple dynamic stochastic model of firm behavior in which the decision to go public is modelled explicitly. We show that such model, without relying on any informational asymmetry or individual irrationality, is able to replicate this and other features that characterize firm dynamics around the IPO date.
We consider the intertemporal decision problem of a risk-averse agent (entrepreneur), with preferences defined over consumption and leisure. The entrepreneur is endowed with a talent for managing, a production technology (firm), and an initial amount of wealth, invested in the firm's equity. Production is assumed to depend on physical capital and on managerial effort. Factors' productivity is stochastic. The entrepreneur can rent physical capital to be used in production along with owned capital (equity). However, the firm can borrow only up to a certain amount, which is an increasing function of its equity.
Within every period, the timing is as follows. First, the entrepreneur has to decide whether to go public or stay private. Going public implies selling stock to outside investors, assumed to be risk neutral. Then, before the productivity level becomes known, the entrepreneur decides how much to borrow. After the shock to the technology is realized, the effort choice is made, production is undertaken, and consumption, dividend distribution, and portfolio decisions are taken.
Going public is costly. First, there are fixed and proportional listing costs. Second, and more importantly, the price at which subscribers are willing to buy the stock is positively related to the stake retained by the initial owner. This happens because, in the absence of a commitment mechanism, rational forward-looking investors expect the managerial effort to increase with the entrepreneur's stake. There are two benefits from going public. First, the IPO allows the firm to overcome the borrowing constraints that keep production at a sub-optimal level. Second, it gives the entrepreneur the chance to unload part of the risk to risk-neutral investors.
The decision to go public is triggered by a sudden and permanent increase
in total factor productivity. As a consequence of such increase, production (sales) expand. Since the level of physical
capital employed in production is set in advance at a level that is lower than
the ex-post efficient one, the return on asset (which equals average
productivity in this setting) increases too. This situation has a real world
counterpart in the case of a firm that enjoys a sudden productivity enhancement
but cannot upgrade its organization instantaneously. Since the entrepreneur
knows that the level of total factor productivity will be permanently higher in
the future, she decides to go public. At the date of the IPO equity increases. Given decreasing returns to scale, the return on assets declines
sharply in the IPO period.
Keywords: Firm Dynamics, IPO, Financing Constraints.
JEL Codes: D21, D92, G32.