Investing in initial public offerings and depository receipts

Abstract

Initial Public Offering of equity is a first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking capital to expand, but can also be done by large privately owned companies looking to become publicly traded. IPO can be a risky investment for the individual investor because it is hard to predict how the stock will do upon listing and in the long run. Numerous academic studies find that IPOs do well in the short run upon listing and decline in the long run.We review this finding in the chapter on Market Efficiency. In this chapter, we review the types of public offers, valuation of IPOs, rationale for cross-border listings, and their valuation. This chapter has the following objectives: • Review the types of issues and the sources of capital for a firm • Highlight who invests in a firm at different stages of life cycle of a firm • Discuss types of IPOs and valuation of IPOs • Discuss the rationale for cross-border listing Firms need capital for investing in real assets and this capital is usually raised in the form of debt and equity. Most of the firms are started by entrepreneurs who may initially use their own money or that of a few of their associates to start the firm. Once the firm is established and operational, it will need additional capital. At this point in time, the business is still in its infancy and may not be ready for a full public issue of capital. The following are the two sources of capital a startup firm can tap into. Angel Investor: Angel investors are mostly high net worth individuals who are willing to invest in startups. Angel investors may provide the seed capital for a startup firm as well as provide the capital at the growth stage of a new business. According to a study by Mason (2001), during the time period of 1999-2000, of all the investments by angel investors in the UK, 59% went to provide the seed money and initial capital for startup firms. The rest of the money mostly went to expansion of business. This study also noticed that 75% of the angel investments were for ℓ100,000 or less. According to the Center for Venture Research, there were 234,000 active angel investors in the United States in 2006. Some studies indicate that even though the average investment by angel investors are smaller compared to venture capitalists, they invest in ten times more startup firms compared to venture capitalists. Venture Capital: In many instances, a group of investors called "venture capitalists" will provide additional equity or debt to the startup firm. Venture capitalists specialize in investing in startup firms and are willing to take the risk of the startup may not succeed at all. Venture capital is usually pooled resources of various investors who are willing to take the risk of investing in startups. But once a startup firm establishes itself and is profitable or expected to be profitable, these venture capitalists may like to pull their investments out of the firm. Since the objective of the venture capitalist is to invest in startup firms, once these firms pass the initial stage of growth, they would like to use the money to invest in other startup firms. Similarly, there may be additional capital needed to fund the growth of the startup firm and the original investors may not have the resources to provide the additional capital. All these will lead the firm to raise additional capital. A firm can raise additional equity capital from two sources - private investors and general public. There are advantages and disadvantages to both types of equity capital. Private equity has less regulatory reporting requirements, but may not be available in sufficient quantity as to meet the capital needs of the firm. It is also possible that depending on the country in which the firm is incorporated, there may be restrictions on the maximum number of shareholders a private firm can have. On the other hand, public equity brings much higher level of regulatory oversight, but will allow the firm to tap into the much larger pool of money available in the capital markets. Another advantage of public issue of equity is that these are usually listed and traded in organized exchanges which provide a much better valuation of the firm. © 2009 Springer-Verlag Berlin Heidelberg.