Venture capital and initial public offerings

Venture capital represents funds invested in a new enterprise. Wealthy investors and financial institutions are the major sources of venture capital. Debt funds are sometimes provided, but it is mostly common stock that is involved. This stock is almost always initially placed privately. Rule 144 of the 1933 Act currently requires that newly issued, privately placed securities be held for at least two years or be registered before they can be resold without restriction.

Limited quantities of privately placed securities can be resold beginning one year after issuance. The aim of this rule is to protect “unsophisticated� investors from being offered unproven securities. As a result, however, investors in these securities have no liquidity for a period of time. The hope of investors in privately placed stock is that the company will thrive and, after five years or so, be large and profitable enough to have the stock registered and sold in the public market.

Initial Public Offerings

If the new enterprise is successful, the owners may want to “take the company public� with a sale of common stock to outsiders. Often this desire is prompted by venture capitalists, who want to realize a cash return on their investment. In another situation, the founders may simply want to establish a value, and liquidity, for their common stock.

Whatever their motivation the owners may decide to turn their firm into public corporation. There are exceptions to this pattern of events; some large, successful companies choose to remain privately held. For example, Bechtel Corporation is one of the largest construction and engineering companies in the world, but its common stock is privately held.

Most initial public offerings (IPOs) are accomplished through underwriters. In an IPO, because the common stock has not been previously traded in the public market, there is no stock price benchmark to use. Consequently, there is IPOs more price uncertainty than there is when a public company sells additional common stock. Empirical studies suggest that, on average, IPOs are sold at a significant discount (over 15%) from the prices that
ultimately prevail in the after-issued market. For the corporation, the implication is that the initial public stock offering will need to be priced significantly below what management believes it should be based on its true value. This difference is the price of admission at the public market. Any subsequent public offering will not need to be under priced by as much, because a benchmark price will exist, and thus there will be less price uncertainty.

When a public company announces a security issue, there may be an information effect that causes a stock market reaction. In studies where other factors causing market movements have been held constant, scholars have found negative stock price reactions to common stock or convertible security issues. Announcements regarding straight debt and preferred stock do not tend to show statistically significant effects. Time around the announcement event is shown on the horizontal axis, and the cumulative average abnormal return, after isolating overall market-movement effects, is along the vertical axis.