Academic journal article Academy of Entrepreneurship Journal

Lessons from the Small Firm Effects

Academic journal article Academy of Entrepreneurship Journal

Lessons from the Small Firm Effects

Article excerpt


The initial public offering (IPO) market for common stock has been both active and extremely cyclical over the past few decades. For instance, a study by Ibbotson, Sindelar, and Ritter (1993) notes that, between 1970 and 1995, more than 8000 firms went public, raising more than $130 billion. During this period, the number of IPOs have ranged from only 9 in 1974 to over 900 in 1986, and the proceeds from these IPOs ranged from $50 million to almost $25 billion.

There are both, demand-side and supply side explanations for the cyclical nature of the IPO market in the US. Choe, Masulis, and Nanda (1993), providing a demand side explanation for the cyclical behavior, suggest that there are periods when exceptionally large number of firms have capital needs which are unlikely to be met by private funding. The internet startups in the mid 1990s are good examples. On the supply side, Loughran and Ritter (1995) suggest that there might be periods when investors that traditionally invest in IPOs have money and the urge to invest. The liquidity surge into internet startups in the late 1990s is a good representation.

A firm considering an IPO or a public offering should be interested in knowing whether a particular hot issue period is demand driven or supply driven. For instance, if the hot issue period is demand driven, entrepreneurs may wish to avoid going public during that time as competition for funds could drive up the cost of capital. On the other hand, the entrepreneur could benefit by timing his IPO to the hot issue periods that are supply driven. Such periods are characterized by high price to earnings ratios, a symptom of lower cost of equity for a new issue.

In this paper we provide further insight on how an entrepreneur might time his IPO to avoid high costs of capital. We suggest that small capitalization stocks have several inherent characteristics that at least temporarily distinguish them from medium and large capitalization stocks. The paper presents evidence on these tendencies, or small firm effects, and goes on to elaborate on how they might impact cost of capital for new issues. The ideas generated in this paper can be employed together with those developed in Choe, Masulis, and Nanda (1993) and Loughran and Ritter (1995) to form a checklist of sorts that could ultimately aid in the effective timing of an IPO.

The main results of our paper may be summarized as follows. First, we demonstrate that small stock prices are more sensitive to the general market when the market is falling than when it is rising. We rule out the possible asymmetry in variance of small stocks across falling and rising markets as a cause for this anomaly. Second, we update prior research and demonstrate a relationship between the sensitivity of small stocks to the general market and the level of business risk: the betas of small stocks are found to be positively related to the spread between Baa-rated and Aaa-rated (default-free) bonds. In other words, we demonstrate that small capitalization stocks are especially sensitive to movements in the overall market when there is a great deal of risk in the market. For IPOs, this translates to an especially high cost of equity when the markets are falling or when the yield spread is high. However, this paper also finds that the yield spread holds little in terms of predictive capacity for the return behavior of small stocks.1

The remainder of the paper is organized as follows. In section II we discuss the nature and significance of the small firm effects and further motivate our empirical section. Section III presents empirical evidence of the small firm effects. Section IV provides some concluding thoughts.


Small capitalization stocks have several behavioral characteristics that distinguish them from medium and large capitalization stocks. For instance, it is well noted that small capitalization stocks are more market-sensitive (have a larger beta) than large stocks, and as they progress to become medium and large capitalization stocks, their beta approaches that of the market. …

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