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Why Do Firms Go Public?

Tuck professor Gordon Phillips finds evidence that an IPO is good for the firm’s bottom line and helps promote commercialization.

For many startups, “going public,” or becoming listed on a publicly-traded stock exchange, is the holy grail of the corporate journey.

It not only signals that the company is mature enough to invite a wide range of investors and be subject to stricter financial regulation, it also allows the firm to raise capital for investments and, hopefully, grow even bigger. And yet, the financial argument for going public has, until recently, been pretty shaky. Research in corporate finance has tended to show a decline in firm profitability after a firm completes its IPO. Previous explanations for the drop in firm profitability include market timing, where the firm goes public at the market’s peak and thus subsequent changes are downward.

Gordon Phillips, the Laurence F. Whittemore Professor and faculty director of the Center for Private Equity and Venture Capital, has always found this conclusion wanting. “People have documented a decrease in profitability for IPOs,” he says, “but there’s no understanding of what would happen if the IPO would not have occurred.” It’s entirely possible that a firm’s profitability would have decreased even further had it not gone public. That “what if” scenario has bedeviled researchers in this field, because it’s difficult to find data on the outcome of an “anti-IPO,” or data on firms that did not go public but wanted to do so.

Our results support the idea that becoming publicly traded provides financial capital to firms … and that firms benefit from this financial capital.

In a new working paper, “The Effects of Going Public on Firm Performance and Strategy: Evidence from International IPOs,” Phillips and his co-authors find a creative way around this problem. Using a unique panel of firms in 16 European countries between 1997 and 2017, they study the firms’ financial data before and after their IPO, and then they compare those numbers to the financial data of firms in that same panel who withdrew their IPO before completion because of exogenous market drops. Their findings reverse previous results and show that firm profitability in fact goes up after an IPO. Moreover, they find that post-IPO firms on average have more subsidiaries and operate in more countries than their counterparts who stayed private.

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Gordon Phillips is faculty director of the Tuck Center for Private Equity and Venture Capital and the Laurence F. Whittemore Professor of Business Administration. He teaches Venture Capital & Private Equity in the MBA program.

Of the more than 3,400 firms the authors study, 422 withdrew their IPO, resulting in an 87 percent likelihood of completion. These firms that abandoned their IPO do provide a good counterfactual to compare with the other firms, but their decision to withdraw was endogenous, meaning that there were likely many unobservable factors at work, thus weakening the comparison. The authors overcome this problem by comparing IPO firms to those that withdrew because of an exogenous shock—in this case, negative market returns during the 30 days prior to the IPO decision. As the authors explain, “market returns in this short window can affect the decision to complete the IPO, but it is unlikely that they directly affect long-run outcomes.” As previous studies have shown, the authors found that positive market returns in the pre-decision period increased the likelihood of IPO completion by 7.2 percent.

When the authors compared the IPO and withdrawn-IPO firms without using the exogenous shock as a differentiator, they found what other researchers before them found: that the return on assets (ROA) goes down after going public, and that the withdrawn-IPO firms displayed a similar decline in profitability. These findings showed the authors that the “post-IPO drop in profitability is sensitive to the choice of the counterfactual,” they write.

But when they account for the exogenous shock in the IPO decision-making, they found a significant increase in profitability associated with going public—a ROA increase of 25 percent. Digging deeper into the variations across countries and industries, the authors found the increase to be stronger in industries with financial dependence, countries with higher levels of disclosure requirement for companies going public, and with more protections in place for minority investors.

It turns out that IPOs do what companies hoped they would do: help them get stronger. “Our results support the idea that becoming publicly traded provides financial capital to firms to help them commercialize previously developed ideas and that firms benefit from this financial capital,” the authors conclude.