Academic journal article Journal of Small Business Management

Does It Pay to Invest in Small Business IPOs?

Academic journal article Journal of Small Business Management

Does It Pay to Invest in Small Business IPOs?

Article excerpt


The need for capital to finance growth and development has been a constant challenge for small businesses. Investors tend to perceive small business investments as riskier than more established vehicles such as blue chip stocks, treasury notes, bonds, and so forth. In the recent past, entrepreneurs have faced high interest rates, the reduction of government-backed loan programs, and a change in the capital gains tax regulations (1978). Taken collectively, these factors have helped to improve the climate for small business initial public offerings (IPOs).

* The authors thank Terry Freeman and Stewart Winograd of the National OTC Stock Journal and Professor Mark Hirschey for their assistance. An earlier draft of this paper was presented at the 30th Annual World Conference of the International Council for Small Business, Montreal, Canada, June 16-19, 1985.

While internal sources and financial institutions provide most of the financing for established businesses, equity investment is especially important to new and growing small firms.1 Many investors in small business IPOs are betting that, due to a lack of generally available information, many stock offerings are initially underpriced2 and should therefore provide higher expected returns.3

1 The State of Small Business: A Report of the President (Washington, D.C.: U.S. Government Printing Office, 1985), pp. 199-244. Also, it has been reported that mutual funds, pension funds, and big institutional buyers, as well as individuals, are beginning to increase investments in newly created small firms (see Alexander L. Taylor III. "Making a Mint Overnight.' Time, January 23, 1984, pp. 44-54).

2 K. R. Rock, "Why New Issues Are Underpriced.' Ph.D. dissertation, University of Chicago, 1982.

3 Jay R. Ritter, "The "Hot Issues' Market of 1980,' The Journal of Business, vol. 27 (1984), pp. 215-240.

The purpose of this study is to investigate the rationale and some of the incentives for investing in the IPO market. Three hypotheses are examined, based upon IPO initial returns and the following characteristics: (1) the age of the IPO firm, (2) offering type, and (3) industry characteristics. The first hypothesis (H1) states that IPOs for less established firms are more underpriced than those for established firms as a means of compensating investors for the cost of becoming informed. The second hypothesis (H2) states that riskier offerings (Best Efforts) will experience higher initial returns than less risky offerings (Firm). The third hypothesis (H3) states that industry effects occur, so that one industry will experience higher initial returns than other industries.


Previously, most IPO studies focused primarily on the occurrence of "hot issues' for which investores received significant positive initial returns. Several different time periods were covered in these studies. For example, Reilly and Hatfield examined the 1964 to 1965 period; McDonald and Fisher examined the first quarter of 1969; Ibbotson, 1960 to 1969; and Ritter, 1977 to 1982.4 Ritter's study further tested Rock's hypothesis that the initial underpricing of a stock reflected greater uncertainty about the IPO firm.5 Angell and Hunt concentrated on the Denver penny stock market to determine whether it was a "hot issues' market during the late 1977 to mid-1980 period.6 Ibbotson and Jaffee examined whether one could predict a "hot issues' market over the 1960 to 1970 period. They found that there was some predictability; however, transaction costs of buying and selling stocks may overwhelm any gains.7

4 Frank K. Reilly and K. Hatfield, "Investor Experience with New Stock Issues,' Financial Analysts Journal (September-October 1969), pp. 73-80; J. G. McDonald and A.K. Fisher, "New Issue Stock Price Behavior,' The Journal of Finance (March 1972), pp. …

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