Since 2000, of the total number of private firms that have gained access to the equity markets for the first time, more have done so through acquisition by another firm (public or private) than through an initial public offering (IPO). While several studies have analyzed and tried to explain this phenomenon (e.g., Gao, Ritter, and Zhu (2013)), far less attention has been paid to an important variable known as the IPO valuation premium, which is the focus of our new paper.
The IPO valuation premium is the difference in the average valuation of private firms exiting through an IPO versus the average value of comparable firms exiting through an acquisition. The IPO valuation premium is relevant to both private firms’ choice between IPOs and acquisitions and the decline in the number of IPOs post-2000, since entrepreneurs whose private firms are able to exit through either mechanism would compare the value of doing so through one or the other. Yet Bayar and Chemmanur (2011) have pointed out that, while many private firms choose to be acquired, the valuation of comparable firms in IPOs is much higher on average than the acquisition values of these firms. A possible explanation is that entrepreneurs hold on to much of their firm’s equity in the long run, and may be aware of the significant overvaluation of the firm’s equity in the IPO market. Our paper aims to analyze the dynamics of the IPO valuation premium before 2000 and after 2000, thereby generating new insights into the IPO valuation premium and the reasons why more companies have exited through acquisitions than IPOs since 2000.
We first develop a theoretical model of the dynamics of the exit choices. The model generates testable implications for the dynamics of entrepreneurs’ exit choice for their firm and, more importantly for our paper, for the dynamics of the IPO valuation premium over the same period. We then empirically test the main predictions of our model for the dynamics of private firms’ IPO versus acquisition choice and for the dynamics of the IPO valuation premium.
Our theoretical model consists of two periods. At the beginning of each period, a set of entrepreneurs (and other current shareholders such as VCs) wish to exit, motivated by a desire either to satisfy their personal liquidity needs or to raise external financing for investment in a new firm project, or both. They can take the firm public, diluting some of their stock but continuing to manage the firm, or they can sell their firm to an acquirer, divesting themselves of all stock in the firm and giving up control to the acquirer. We analyze each alternative.
An important factor in the private firm’s exit choice is competition in the product market. While a stand-alone firm must fend for itself after going public, one that is acquired may receive considerable support from the acquirer in the product market. Each entrepreneur has private information about own firm, which determines its probability of success in product market competition. While individual investors in the IPO market are usually at an informational disadvantage the entrepreneur, potential acquirers can value the firm based on their industry expertise and knowledge about alternative business models. One downside of an acquisition for the entrepreneur, however, is that he will lose the private benefits of controlling the firm subsequent to the acquisition.
In the above scenario, we show that the firms whose probability of success in product market competition is above a certain threshold chose to exit through an IPO, since they place a lower value on help from acquirers. Firms below that threshold chose to exit through an acquisition. The IPO valuation premium is positive in each period in the above setting, since the average value of firms above the quality threshold for going public is higher than the average values of firms that are acquired (even after accounting for the acquisition synergy arising from the help provided by the acquirer to the target private firm, which increases the latter’s probability of success in product market competition).
We next introduce a positive shock to the acquisition synergy provided by acquirers to exiting private firms between the first and second periods of the above dynamic model, and study how the nature of the exit choice equilibrium changes between the first and second periods. We develop four testable predictions based on our theoretical model. First, the threshold value of the probability of success above which private firms choose to exit through an IPO rather than an acquisition increases in the second period (which we view as 2001 and after in our empirical analysis) compared with the first period (2000 and earlier years). This implies that the average market value of firms going public will be higher in the post-2000 period. Second, for reasonable values of the acquisition synergy shock, the IPO valuation premium remains positive in both periods. Third, the change in the IPO valuation premium between the two periods (from pre-2000 to 2001 and beyond) may be positive or negative. That is, the IPO valuation premium may increase or decrease between the two periods. This is because the IPO valuation premium is the difference between the average values of firms going public, which is greater in the post-2000 period (the “IPO quality change effect”), and the average values of firms that are acquired, which is also greater in the post-2000 period by virtue of the positive synergy shock between the two periods (“acquisition synergy shock effect”). In other words, the change in IPO valuation premium across the two periods will depend upon whether the “IPO quality change effect” is greater or less than the “acquisition synergy shock effect” across the two periods. Fourth, the change in the IPO valuation premium from the period before 2000 to the period after 2000 will be greater for firms with product markets (in industries) characterized by a larger acquisition synergy shock.
We test the above predictions using a sample of private firms that were either acquired or had IPOs between 1995 and 2019. Our sample consists of 2,523 private firms that were acquired during this period (and that had at least one year of financial data prior to the acquisition) and 2646 private firms that went public during this period. We found, first, that the fraction of exiting firms that chose an IPO over an acquisition declined significantly in the post-2000 period from the pre-2000 period. Second, the IPO valuation premium remained positive in both the pre-2000 and post-2000 periods. In our empirical analysis, we calculate the IPO valuation premium in each period by matching each acquired firm with comparable IPO firms, computing the difference in their valuations, and averaging across all acquired firms in that period. Third, the IPO valuation premium shrank significantly from the pre-2000 to the post-2000 period. Fourth, the reduction in the IPO valuation premium was significantly larger in the case of private firms in industries where the ability of potential acquirers to help exiting private firms is greater, namely, in more concentrated industries and in industries where the leading public firm had a greater market share.
When we split our sample between VC-backed and non-VC-backed private firms, the decline in the IPO valuation premium is insignificant (across all industries) in the VC-backed subsample, while it is significant in the non-VC-backed subsample. This may reflect, in addition to the product market considerations captured in our theoretical model, the increased availability of VC-financing post-2000. Ewens and Farre-Mensa (2020) argue that the deregulation in securities laws, especially the passage of the National Securities Markets Improvement Act (NSMIA) in the late 1990s, made private equity financing more available to private firms (especially to later stage private firms) in after 2000. This increased availability may have raised the threshold quality of firms going public in the post-2000 period by motivating many firms that may have otherwise gone public to remain private, so that the IPO quality change effect (the first term in the IPO valuation premium calculation) is likely to be greater for VC-backed firms post-2000. On the other hand, since VC-backed private firms are likely to be of higher quality than non-VC-backed firms, the acquisition synergy shock is likely to be smaller in VC-backed private firms. Given that the above two effects together determine the change in the IPO valuation premium from pre- to post-2000, it is not surprising that the reduction in the IPO valuation premium is smaller in VC-backed firms than in non-VC-backed firms. However, in those industries where the leading publicly-listed firms have greater market power, the reduction in IPO valuation premium is significant even in the VC-backed subsample, suggesting that the product market competition considerations driving our model continue to be important even in the VC-backed subsample.
Finally, when we split our sample between firms that do and do not engage in substantial amounts of research and development, the reduction in the IPO valuation premium is significant only for the latter firms. These results may reflect the fact that firms investing more in R&D are likely to be in more innovative and knowledge-intensive industries, so that the product market considerations we capture in our theoretical model (i.e., help from acquiring firms to exiting private firms in product market competition) may be less important in such industries, since more innovative firms may be able to disrupt the business models of their competitors. On the other hand, we find that, for firms that do not do much R&D, the reduction in IPO valuation premium is greater where the leading publicly listed firm has greater market power, consistent with our model predictions.
We next dig deeper into what causes the reduction in the IPO valuation premium from before 2000 to after. We conduct two identification tests. First, we conduct a direct test to see whether the reduction in the IPO valuation premium from pre- to post-2000 is driven by a positive shock to acquisition synergy between the two periods, as we postulate in our model. Consistent with our model’s predictions, we find that the decrease in the IPO valuation premium in the post-2000 period is indeed greater in industries characterized by larger acquisition synergy shocks, indicating causality.
Second, we conduct an instrumental variable (IV) analysis to address any potential endogeneity in our baseline analyses. We find that our main findings about the dynamics of the IPO valuation premium and its interaction with product market competition variables remain robust to this IV analysis. This shows that our baseline analysis results are causal, and that increases in acquisition synergy from pre- to post-2000 are indeed an important driver of the IPO valuation premium from pre- to post-2000.
Bayar, O., and Chemmanur, T.J., 2011. IPOs versus acquisitions and the valuation premium puzzle: A theory of exit choice by entrepreneurs and venture capitalists. Journal of Financial and Quantitative Analysis 46, 1755-1793.
Ewens, M., and Farre-Mensa, J., 2020. The deregulation of the private equity markets and the decline in IPOs. Review of Financial Studies 33(12), 5463-5509.
Gao, X., Ritter, J.R., and Zhu, Z., 2013. Where have all the IPOs gone? Journal of Financial and Quantitative Analysis, 48(6), 1663-1692.
This post comes to us from professors Onur Bayar at the University of Texas at San Antonio, Thomas J. Chemmanur at Boston College’s Carroll School of Management, Christos Mavrovitis (Mavis) at the University of Surrey, and Evangelos Vagenas-Nanos at the University of Glasgow. It is based on their recent article, “The Dynamics of Entrepreneurial Firm Exit Choice and the IPO Valuation Premium: Theory and Evidence,” available here.