1 Finance I (Corporate Finance), fall 2008 - L 9 (2008_09_29)
Junghun Cho, junghun.cho@cerge-ei.cz, home.cerge-ei.cz/cho, room 327 x121
Andreas Ortmann, andreas.ortmann@cerge-ei.cz, home.cerge-ei.cz/ortmann, room 332b x117 Teaching assistants:
Jana Krajcova, jana.krajcova@cerge-ei.cz, Svitlana Zhylenko, szhylenk@cerge-ei.cz
Exercise sessions, by popular demand, now Thursdays at 8:45-10:15; problem sets due in my mailbox on Tuesdays midnight. I try to make problem sets available Wednesdays evening of the preceding week on the website. See Svitlana’s message.
Office hours: just stop by at your convenience (I may even offer you an espresso !), or make an appointment.
PLEASE RECALL THAT TERM PAPER TOPICS HAVE TO BE APPROVED BY ME OR PROFESSOR CHO; I URGE YOU TO STOP BY MY OFFICE (OR PROF CHO’s OFFICE) TO DISCUSS APPROPRIATE TOPICS. IT IS FINE WITH ME IF YOUR TERM PAPER OVERLAPS WITH YOUR ENGLISH ASSIGNMENT.
There are, incidentally, two RMS sessions upcoming (October 14, 9:00 – 10:30 and October 21, 16:30 – 18:00 about how people do their research.)
Make sure to bring the article by Banerjee and Dufflo for next lecture … Reading assignments and problem sets see …
http://home.cerge-ei.cz/ortmann/corp_finance/CorpFinance.html
Professor Cho will start teaching October 20. The exam for my part will take place either December 8 (as part of the final) or Sunday October 19
Please recall: The lecture notes are exactly that. They are my notes (mistakes and all) for the lecture. Nothing more. They are not a transcript of the lecture.
Summary of last lecture:
I summarized what we did the previous class.
I then presented the basic Variable/Continuous Investment model in Tirole. For details see what was handed out. (Please note: The online notes do not contain the handwritten
segments.) The model overcomes an obvious drawback of the FIM … (non-scalability of investments, nothing to say about borrowing capacity).
We then went over the key ideas informing Yossi Spiegel’s excellent seminar a couple of weeks ago on the choice between divisional and functional organizational form, and the double Moral Hazard problem that makes it interesting.
We then discussed for a relatively short amount of time and (after a brief discussion of some of the material from Ross et al. ) the article by Ritter and Welch; at the end I gave out my suggested answers to the questions]
Today we return to the FIM; we then discuss the article by Kaplan, Sensoy, and Stroemberg:
[HERE 3 PAGES – distributed in class only -- OF HANDWRITTEN NOTES ON EXTENSIONS OF TIROLE’s BASIC FIXED INVESTMENT MODEL AND THE CONTINUOUS INVESTMENT MODEL]
3 The Going Public decision … (Tirole 92 – 95)
- Going public – as we have seen – is costly indeed.
- substantial underpricing (money left on the table, sometimes the amount being increased through Green Shoe / overallotment provisions, see RWJ p. 522) - substantial underwriting and legal fees
- provision of detailed information, on a regular basis, to regulators and investors, and for that matter product market competitors
- handing over some control rights (although arguably less than to VCs) - So why would anyone in their right mind go through the trouble of going public?
Well, where there are costs there often are benefits:
- new sources of finance and therefore opportunities to grow
- decreased reliance on private funding through VCs or private debt (and therefore decreased dependence on one key financier)
- diversification of their own portfolios for entrepreneurs and large shareholders (the fact that someone sells some stake in their company is not necessarily a bad sign!)
- signal to the market about a governance structure that’s up to snuff - opens doors for “independent” evaluation of firm assets and prospets and as well as takeovers (which has disciplining effect of managers0
- provides additional means of compensation
- enhances name recognition
Guiding questions (and suggested answers) to Ritter and Welch 2002, A Review of IPO Activity, Pricing and Allocations. The Journal of Finance LVII.4: 1795 - 1828.
1. What exactly is it that Ritter and Welch do? (abstract, intro, conclusion)
- study the patterns, for years 1980 – 2001, in issuing activity, underpricing, and long- run underperformance by way of a review that focuses on recent papers (What the selection criteria?)
- focus on US situation
- find that 1980s saw modest IPO activity, then the double the issuing volume for 1990 – 1994 ($20 b), then again double the issuing volume for 1995 – 1998 ($35 b), then again double the issuing volume for 1999 – 2000 ($65 b), before reverting to 1995 – 1998 levels. See also Table I.
- find that average first-day returns follow a similar qualitative pattern (albeit 1999 – 2000 numbers more than three – four times as high 65 % than in the years
immediately before and after. See also Table I.
- find that three-year market-adjusted buy-and-hold returns are negative in every subperiod (but not for every cohort) See also Table I.
- try to find explanations for these stylized facts - identify issues that are still contentious
2. What are the (three) most remarkable insights to be gleaned from Table I? (p. 1797) Make sure you understand what market-adjusted IPO returns are. Make sure you also understand what style-adjusted returns are, and what an important issue is that plagues the IPO literature in this respect. (See p. 1817).
- (as always in such a context that is to some extent a judgement call)
- the aggregate money left on the table in 1999 – 2000? (average first-day return of 18.8 percent!)
- the average 3-year buy-and-hold return for the same years?
- the issuance and average first-day return patterns already discussed?
- “Market-adjusted returns are calculated as the buy-and-hold return on an IPO minus
… .” (see the legend to Table I; in essence the returns on IPOs are measured against some market benchmark.)
- The “style-adjusted” data are computed by matching firms that go through IPO with firms that are similar in market capitalization and book-to-market valuation. Since
5 themselves with the complex public market process. … Stepping outside our own sample … “ (R&W 1796, 1798) What sample are R&W talking about?
- I do not know where they got their insights from. Notwithstanding their comment on p. 1802 that the hard facts in Table I draw on 6,249 IPOs from 1980 to 2001.
4. “Many IPOs are not so much exits for the entrepreneur as they are for the venture capitalists.”
(p. 1798) Why?
- Entrepreneurs often regain control from VCs at the IPO
5. R&W propose (p. 1799), in addition to rational theories for IPO volume fluctuations, a plausible semirational theory without asymmetric information that allegedly can explain cycles in issuing activity. What is it? And what’s (obviously?) wrong with it?
- Entrepreneurs derive their sense of enterprise value from their internal perspective and day-to-day involvement rather than market valuation. Entrepreneurs, the authors propose, adjust their valuation with a lag. What’s wrong with it: It seems to implicitly assume that entrepreneurs think and act in lock-step. Plus, it seems not clear why you would see the patterns that we saw in Fig 16.3 RWJ.
6. What are the key findings of Pagano et al. (1998) and Lerner (1994)? What’s the common denominator of these sets of findings? See p. 1799.
- Pagano et al. (1998) – in Italy only large companies and companies industries with high market-to-book ratios are likely to going public [see caveat in Tirole on the specifics of thi set of Italian firms]
- Lerner (1994) – in US biotechnology sector industry market-to-book ratios also have (substantial) effect on decision to go public.
- Common denominator: over-optimism (about growth opportunities), availability of cheap money
7. What are the most remarkable insights to be gleaned from Table II? (p. 1800, also narrative p.
1801) In light of the IPO three-year returns reported in Table I, how to you reconcile column 4 (“percentage of IPOs with EPS < 0”) with the findings reported in Table I.
- See narrative pp. 1800 - 1801 - Trivial ☺
8. What are the most remarkable insights to be gleaned from Table III? (p. 1806)
- only about half of the IPO offer prices lie within the original range, with the other half lying about evenly to the left and right. So, obviously there is a lot of uncertainty there initially regarding the value of the companies that are going public.
- the conditional mean first-day returns and % of first-day returns differ nonetheless systematically. (In what direction?)
9. “In common with many other signaling models, high-quality firms demonstrate that they are high quality by throwing money away. One way to do this is to leave money on the table in the IPO. On theoretical grounds, however, it is unclear why underpricing is a more efficient signal than, say, committing to spend money on charitable donations or advertising,” (p. 1803) Discuss briefly. Do you agree?
- Strikes me as a silly comment, on theoretical grounds. The beneficiaries of charitable donations or advertising and of IPO underpricing are rather different sets of
consumers. That should be reflected both in the quantity demanded as well as in the demand.
Comment 1: Table 4 is useful but it is not clear what exactly the inclusion criteria were and what the reference class of articles is.
Comment 2: Footnote 10 is rather interesting. Why if, it seems, auctions are more efficient (in the sense of producing less underpricing) than the current mechanisms of selling IPOs, are they not being used?
Comment 3: The Ljungqvist and Wilhelm (2002b) study briefly discussed on p. 1811 is also very interesting.
Comment 4: Accounting for the fact that the article was published in 2002 (and apparently written in late 2001), read carefully the summary of section II. on IPO pricing and allocation on page 1816,
Comment 5: As you may have noticed, the issue of the long-run performance of IPOs gets us quickly into tricky econometrics issues that we will not deal with in this course. But read carefully the caveats on p. 1820 – 1822.
7 Guiding questions and suggested answers to Kaplan, Sensoy, and Stromberg 2008, Should Investors Bet on the Jockey or the Horse? Evidence from Early Business Plans to Public Companies. Manuscript.
1. What’s the basic purpose of the manuscript (and what is the basic finding)?
- to explore what matters more: the business idea [the Horse] or the
management team [the Jockey]. Looks like there is a real egg-hen problem here: Is it not (parts of) the management team that comes up with the idea?
- “The results for both of our samples indicate that firms that go public rarely change or make a huge leap from their initial business idea or line of business.” (p. 4; see also p. 29 for similar statement.) And, “An initial strong business, therefore, may not be sufficient, but appears to be necessary for a company to succeed. … it is common for firms to replace their founders and initial managers and still able to go public, suggesting that VCs are regularly able to find management replacements or
improvements for good business. We interpret our results as indicating that on the margin, VCs should spend more time on due diligence of the business rather than management.” (p. 29)
- When reading the manuscript it might clarify issues if you compare the various findings and statements to a nonprofit like CERGE-EI.
2. Both of our samples? What samples do the authors use? Why?
a. A sample of 50 VC-backed firms, of which were part of earlier Kaplan &
Stromberg studies (pp. 7 – 8)
b. A sample of 106 non-financial 2004 start-up IPOs (whittled down from a total of 306 in 2004 for various reasons; see p. 25).
c. This is a robustness test because the main sample of 50 VC-backed firms is afflicted with various sample selection “issues” (see pp. 9 – 10).
i. Only analysis of VC-backed companies
ii. VC-backed companies in sample may not be representative
iii. Majority of companies in sample were funded in tech boom (so may also not be representative because money was flowing relatively freely then) iv. Only analysis of firms that go public.
v. Main sample over-represents (more than twice than benchmark share) investments in biotech and healthcare and under-represents software, information technology, and telecom relative to the overall VC market (p.
10) In their analysis they distinguish results of biotech and nonbiotech firms at various junctures.
d. They do not study failed start-ups, or firms that have been acquired, or firms that survive but do not go public. Difficult to get the data.
3. What data exactly do the collect?
a. Copies of the business plans and/or the VC investment memo [business plan], IPO prospectus information [IPO], company’s annual report that is closest to 36 months after the IPO [Annual Report].
b. Data on financial and employees, *business (line changes), points of
differentiation, asets and technology, growth strategy, customers and competitors,
*management, *ownership (pp. 10 – 23 for main sample and 26 – 28 for robustness check)
4. Interesting results (non-ordered sample):
a. “Consistent with our sample strategy, the sample firms experience dramatic growth in revenue, assets, and market value … . While the firms grow
dramatically, their core business or business ideas appear remarkably stable. Only one firm changes its core line of business [table 3, panel E, AO] … .” (p. 3) “To address concerns that our sample of 50 VC-backed firms might be special in some way, we repeat our analyses of line of business changes, … for all nonfinancial start-ups firms that went public in 2004 – both VC and non-VC backed. We obtain qualitatively similar results to those in our primary sample. We find that 7.5% of the firms change their business lines. While this is somewhat greater than the 2% for our main sample, it is still small in an absolute sense.” (p. 4)
- “At the business plan, the median company reports no revenue in the prior fiscal year. Average revenue is $5.5 million, reflecting seven firms with revenues over $10 million. Most of our firms, therefore, are very young. … At the IPO, the median and average revenue figures increase dramatically to $7.3 million and $42.3 million (although four companies go public with no revenue in the latest fiscal year). By the annual report, revenues increase by another order of magnitude, to a median of $69.1 million and an average of $252.7 million. … “ (pp. 10 – 11)
- “Asset growth for the sample parallels revenue growth, … “ (p. 10)
- “The median company has 22 employees at the business plan, 129 at the IPO, and 432 at t he annual report. Retailers tend to be somewhat more labor-intensive than others in our sample. The median number of employees for non-retailers is 18, 102, and 328 at the business plan, IPO, and annual report.” (p. 10)
b. “Rather than changing businesses, firms typically maintain or broaden their offerings within their initial market segments.” (p. 3)
c. “Almost uniformly, firms claim that they are differentiated by a unique product, technology, or service at all three stages we examine.” (p. 3)
d. “While the points of differentiation, alienable assets, customers, and competitors remain relatively constant, the human capital of the sample firms changes more substantially. Only 72% of the CEOs at the IPO were CEOs at the business plan;
only 44% of the CEOs at the annual report were CEOs at the business plan. The analogous percentages are lower for founders. Similarly, only about 50% of the next four top executives at the IPO were top executives at the business plan; only
9 and the management team (jockey). … The results for both of our samples
indicate that firms that go public rarely change or make a huge leap from their initial business idea or line of business. This suggests that it is extremely important that a VC pick a good business. At the same time, firms commonly replace their initial managers with new ones and see their founders depart, yet still are able to go public, suggesting that VCs are regularly able to find management replacements or improvements for good businesses.” (pp. 4 – 5, see also p. 29 top paragraph)
f. “ … the results do not imply that good management is not important. The large equity incentives VCs provide to new management suggest that good
management is valuable. However, the results suggest that poor or inappropriate management is much more likely to be remedied by new management than a poor or inappropriate business idea is to be remedied by a new idea.” (p. 5)
g. “The theories of Hart-Moore-Holmström assume that a firm must be organized around non-human capital assets. We find that non-human capital assets form very early in a firm’s life. Identifiable lines of business and important physical, patent, and IP assets are created in these firms by the time of the early business plan, are relatively stable, and do not change or disappear as specific human capital assets turn over. … . This should not be interpreted as saying that specific human capital is unnecessary or unimportant. Obviously, a specific person has to have the initial idea an start the firm.” (p. 5)
h. “Table V indicates that patents and physical assets become increasingly important from the business plan through the annual report. At the business plan, 42% of companies own or are the exclusive licensees of patents; at the IPO, 60%; and at the annual report, 66%. While patents and exclusive licenses are significantly more important for biotech firms, they also are important for non-retail, non- biotech firms. Physical assets are relatively unimportant for biotech firms and always important for retailers. Physical assets become increasingly important for non-retail, non-biotech firms, going from 11% to 26% to 50% from business plan through annual report. Combining patents and physical assets as alienable assets, we find that 56%, 78%, and 84% of the firms have such assets, respectively, at the business plan, IPO, and annual report. Proprietary intellectual property is
important for almost all of the non-retail firms – both biotech and non-biotech.
Intellectual property, therefore, whether patented or not, is substantially more important than physical assets. This implies that the non-retail companies in the sample are based largely on ideas or knowledge rather than physical capital. This is consistent with arguments in Zingales (2000) that firms are increasingly defined by intellectual rather than physical capital.” (p. 16) [non-alienable assets create hold-up problems]
i. “Involvement of founders declines steadily over time. By the IPO, only 58% of the firms have a founder CEO although 94% still have a founder as a top executive or a director. By the annual report, 38% of the firms have a founder CEO, while only 69% still have a founder as a top executive or director. This suggests that over time, founders move from operating positions to board positions to no involvement.” (p. 18) [Overall, turnover is indeed substantial.]
j. “Founder ownership declines sharply from a median of 31.7% at the business plan to 12.5% just before the IPO to 9.0% immediately following the IPO. Because founders typically are not allowed to sell any shares until six months after the IPO, this indicates that founders give up a large fraction of their ownership stakes to attract VC financing and/or outside management talent. Founder ownership continues to decline after the IPO to a median 3.2% at the annual report. This decline reflects founder stock sales as well as issuance of additional stock. CEO ownership also declines as the firm ages: the median CEO owns 15.8% of the company at the business plan, 7.0% pre-IPO, 5.4% post-IPO, and 3.2% at the annual report. The six CEOs who are not founders own a median 5.5% of the company at the time of the business plan. The 21 non-founder CEOs at the IPO own a median of 4.2% the company just before the IPO. One can interpret these results as indicating that VC-financed companies allocate roughly 5% of the company’s equity to attract and provide incentives to an outside CEO.” (pp. 20- 21)
k. “Overall, the calculations … indicate a range of 10.8% to 19.6% as the value of the firm that founders retain for their ideas or initial contributions that is not related to ongoing incentives.” (p. 23)
