Where Have All the IPOs Gone?

During 1980-2000, an average of 311 companies per year went public in the U.S. Since the technology bubble burst in 2000, the average has been only 102 initial public offerings (IPOs) per year, with the drop especially precipitous among small firms. Many have blamed the Sarbanes-Oxley Act of 2002 and the 2003 Global Settlement’s effects on analyst coverage for the decline in U.S. IPO activity. In our paper, Where Have All the IPOs Gone?, which was recently made publicly available on SSRN, we introduce a new explanation for the prolonged low level of U.S. IPO volume. We posit that there has been a structural change in the U.S. IPO market, driven by structural shifts in the economy that have reduced the profitability of small companies, whether public or private. Our analysis is based on the technological determinants of the optimal scale of the firm in a dynamic environment, where profitable growth opportunities may be lost if they are not quickly seized. We posit that many small firms can create greater operating profits by selling out in a trade sale (being acquired by a firm in the same or a related industry) rather than remaining as an independent firm. Earnings will be higher as part of a larger organization that can realize economies of scope and bring new technology to market faster.

Our explanation can be summarized as “Firms are being acquired rather than going public because in many industries a small firm is worth more as part of a larger organization than as an independent firm, whether it is public or private.” Thus, we are in agreement with the conventional wisdom that attributes the drop in the number of small company IPOs to low public market prices relative to their valuations in a trade sale. The conventional wisdom, however, states that the low public market price is due to either a lower price-to-earnings ratio due to the lack of analyst coverage, or to lower earnings as a public firm because of SOX and other costs. In contrast, our explanation is that earnings are higher as part of a larger organization, and this regularity is the main reason why many small firms are choosing not to remain independent. If our explanation is correct, regulatory reforms aimed at restoring the IPO “ecosystem” will have only a modest ability to affect IPO volume. Instead, IPO volume is unlikely to achieve the number of deals routinely reached in much of the 1980s and 1990s.

We show that the drop in IPO volume has been concentrated among small firms, a pattern that has been widely noted. We report that among small firm IPOs, the percentage that are profitable in the three years after going public has declined from 42% in 1980-2000 to only 27% in 2001-2009. In contrast, for large company IPOs there has been no downtrend in post-IPO profitability. We also show that for the last three decades the long-run returns earned by investors on small company IPOs have been poor, with the relative performance of small company IPOs particularly disappointing after 2000. Taken together, these patterns suggest that while SOX and the Global Settlement may have had some effect on small company IPOs, the more fundamental problems are the lack of profitable small company IPOs and the lack of small company IPOs that grow and become highly profitable, earning high returns for investors.

Restating our hypothesis, we are saying that the lack of IPOs is not so much a private firm versus public firm choice, but instead is a small independent firm versus a larger firm choice. We are arguing that in many cases the profits of a small independent firm will increase by becoming part of a larger organization that can realize economies of scope and speed new technologies to market. To achieve this, for venture capital-backed startups, trade sales have increasingly become the preferred way to exit because the company would be less profitable as a stand-alone entity.

Evidence from a variety of sources is consistent with our explanation for the reduced number of U.S. IPOs in the last decade. There have not been a large number of U.S. firms fleeing the U.S. and going public overseas. Foreign firms have continued to go public in the U.S. The volume of IPOs in many other developed countries, especially in Germany and France, has also been quite modest after 2000. Of companies that do go public in the U.S., there has been no drop in analyst coverage. Furthermore, for the firms that do go public, many either are acquired or make acquisitions within a few years of going public. They do not rely exclusively on organic (internal) growth to grow large. Of those that are acquired, most are acquired by other publicly traded companies, and there has been no increase in the fraction of acquisitions by private companies or buyout firms. In other words, those that voluntarily delist are not going private as a stand-alone company in an attempt to avoid SOX costs, nor do they delist because of little analyst coverage.

Bayar and Chemmanur (2011) model the choice of going public as a tradeoff between an entrepreneur retaining the private benefits of control by staying private and realizing higher wealth due to economies of scale and scope due to the proceeds received in going public. Our analysis goes a step further, and hinges on the argument that by selling out rather than going public, the firm is able to achieve even greater economies of scale and scope. Because we are interested in explaining the time series rather than the cross section of IPO activity, we do not focus on private benefits of control, since we are not aware of any reason to think that they have changed over time.

Additional explanations for the decline in IPO activity have been offered by Angel (2011) and others. Among these additional explanations are that the litigation environment in the U.S. imposes costs on public firms. It is not clear, however, whether the litigation environment worsened this decade in comparison to the 1980s and 1990s. Furthermore, although class action securities litigation is a problem only for public firms, “patent trolls” are a problem for both private and public companies. Another explanation for the low volume of IPOs after the tech stock bubble burst in 2000 is the lower public market valuations due to the bear markets in 2000-2002 and 2008. Yet, in 2007 the S&P 500 returned to the same 1,500+ level that it achieved in 2000 without IPO volume soaring. Furthermore, IPO volume peaked in 1996, far before stock market valuations peaked. Therefore, neither the litigation risk nor the market valuation explanation is compelling.

The full paper is available for download here.