BYU Study Clarifies Misunderstood Motivations Behind IPOs

PROVO, Utah — Feb 14, 2006 — A face-off between academics and chief financial officers may not sound like the most electrifying of showdowns, but a new Brigham Young University study that pits generally accepted theories against real-world behavior has important implications for investors considering companies' initial public offerings.

Flying in the face of the theory that companies go public to minimize the cost of the money they need to grow, the research by business professors James C. Brau and Stanley E. Fawcett reveals that the most important motivation for an initial public offering is to create public shares for use in future acquisitions.

Academics argue that at some point a company will run out of its own money and will be unable to take on more debt without paying exorbitant interest rates. With bank financing out of the question, a business would be forced to raise money via an initial public offering to minimize the cost of money needed to grow.

"It's here that we find one of the biggest disconnects between (CFO) practitioners and academics," said Brau, an associate professor of finance in the Marriott School of Management. "The practitioners say that they aren't going public to minimize the cost of capital, which the academics think is a primary reason, but to create this currency for acquisitions."

Once a company is public, it has easily traded shares that act as a currency for acquiring and being acquired, said Brau. "The company can either use shares to buy other companies in so-called 'stock transactions,' or be bought itself."

One highly publicized example of such a transaction was when Yahoo! purchased newly public Broadcast.com in 1999 from Mark Cuban for a reported $5.7 billion in Yahoo! stock, which Cuban eventually sold and used to buy the NBA's Dallas Mavericks.

The study, published in the Feb. 15 issue of the "Journal of Finance," details Brau and Fawcett's work surveying 336 CFOs from a mix of companies that had successfully gone public, withdrawn a bid to go public or chosen never to go public. The researchers used the companies' responses to determine how well attitudes and practices meshed with the latest academic ideas regarding IPOs and compared survey results to publicly available financial data to see how well survey results reflected actual performance.

"In some cases we found that the academic theory was well grounded and that the CFOs agreed with what academics had concluded," said Brau, the Goldman Sachs Faculty Fellow at BYU. "In other cases, mainly in issues surrounding motivation and timing, we found that there was a little bit of a disjoint between the CFOs and academia."

Post-IPO data confirmed that there is a higher incidence of newly public companies that participate in mergers and acquisitions relative to established companies, said Brau. But the data also revealed a twist. Companies that have recently completed an IPO are more likely to be acquirers than to be acquired.

"To be honest, that was surprising to me," said Brau. "I thought companies would go public and get gobbled up, but the data show the opposite. Publicly available data suggests that newly public firms are using their new shares to grow through acquisition."

Brau and Fawcett's research should give the average investor a better, more cautious understanding of why a company chooses to go public, said Brau.

"It's not just as simple as a company needs more money to take things to the next level," he said. "Many times, that's not the reason a company is going public at all."

The study's second main finding focused on why companies choose to time their IPOs when they do.

"What we found – and it's not surprising – is that insiders are opportunistic, seeking to take their companies public when they can get the highest stock price," said Brau. "We've known about this in the past, but our survey gives evidence that it's a strategic decision. This is one of the reasons that secondary investors often overpay for an IPO."

Furthermore, the data showed that companies backed by venture capital funding tend to be more aggressive when it comes to timing an IPO, said Brau. "Companies often use overall market and industry conditions to judge the strength of the market when they go public, and not IPO market conditions, as was previously thought by some."

Brau also noted that all of these timing issues advocate caution when investing in IPOs.

"Sure, you have your 'Googles' that shoot to the moon, but investors need to understand that, on average, IPOs under perform similar, seasoned companies over the long run."