Initial Public Offerings (IPOs) in the United States have declined since the mid-1980s; IPOs have gone from an average of 300 per year between 1980 and 2000, to an average of 100 per year between 2000 and 2017. According to Davidoff Solomon, a professor of law at UC Berkeley, 706 companies went public in 1996, but only 105 did so in 2016. This article will provide some historical background for the U.S. IPO market, discuss several viewpoints on why IPOs are declining, and analyze how these changes affect young companies today.
The number of U.S. IPOs in 2016 was less than 15% of the U.S. IPO total in 1996. To understand the various theories seeking to explain this decline, it is important to have a broad perspective of the U.S. IPO market. The following diagrams illustrate the number of IPOs that occurred in the U.S. over the course of the 55 years between 1960 and 2015, broken out by decade in Figure 1, and by year in Figure 2.
Figure 1. Data from Jay Ritter’s website
Figure 2. Data from Jay Ritter’s website
Over the course of the 55 years illustrated in the diagrams above, many changes in the marketplace have affected how securities are issued and traded. In the last 21 years alone, there have been many large changes. Some of the important changes—several of which are the basis of a few theories explaining the recent decline in U.S. IPOs—are as follows:
- Near the end of 1996, the SEC adopted some amendments to the Quote rule1, which are collectively referred to as the Order Handling Rules. These rules require a market maker to display in their quote price any orders placed in an Electronic Communication Network (“ECN”)2.
- In 1998, the SEC introduced Regulation ATS to protect traders using alternative trading systems (“ATS”)3.
- In April of 2001, the SEC required all stock markets to switch over to the use of decimals rather than fractions when listing prices in a process called decimalization.
- In July of 2002, Congress passed the Sarbanes-Oxley Act which required additional disclosures and tighter accounting controls in an attempt to protect investors and the public from fraud.
- In June of 2005, the SEC passed Regulation NMS4 in an effort to provide greater protection in the equities market.
- In April of 2012, the JOBS Act5 was passed to increase the growth of startups in the US.
The exact impact of these changes on IPOs in the U.S. is difficult to know for certain, but the fact that they have influenced the listing and trading of public entities is undeniable.
Historical and Economic Significance of IPOs in the United States
Historically, IPOs have provided a way for the investing public to participate in the growth of a company, while also providing them with a place to park a portion of their retirement. Companies like Amazon and Microsoft are great examples of successful companies that listed on a stock exchange early in the company’s history, providing individual investors with an opportunity to share in the wealth these companies have created. If, for example, you had invested in Microsoft on the day that it opened trading on the public market, you would have paid $28 per share. Assuming you purchased 100 shares that day for a total investment of $2,800, as of November 22, 2017 you would own a total of 28,800 shares as a result of stock splits, and the value of your shares would be $2,402,208.
In addition to wealth creation, the listing of companies on public exchanges has provided several other important benefits to the nation’s economy. One of these benefits is the ease of information gathering, and with that information, the knowledge needed to make smart investing decisions. Once a company is publicly listed, investor confidence can be more easily obtained than was previously the case under private ownership. This is due to the accounting, legal, financial, and social regulations placed on public companies. These regulations help to provide investors with a certain level of assurance that what a company claims to be true regarding their financial wellbeing, is true.
Causes of the Decline
Both the causes and implications of the decline in U.S. IPOs are widely debated topics. The following theories represent the most frequently discussed and accepted opinions for this decline, and will be the focus of this article:
- Fear of red tape and its associated costs
- Selling out
- Liquidity and administrative costs
- Efficient private market
- IPO waves
Fear of red tape and its associated costs – One theory for the falling number of U.S. IPOs over the last 20 years blames the decline on regulatory constraints, referred to as “fear of red tape” by the Economist. Supporters of this argument believe that Sarbanes-Oxley and other regulations have made it far too expensive and time consuming for companies, especially SMEs6 to go through an IPO. According to this theory, thanks to added regulation, an IPO now requires so much additional time and money that it is nearly impossible for a small- or medium-sized company to go public. In addition to these large upfront costs, the required disclosures and other regulatory requirements are so burdensome that companies prefer to remain privately held, despite the potential growth opportunities they may be missing out on.
In an article published by Credit Suisse and authored by Michael Mauboussin, et al., the rising costs associated with being a publicly-listed company are cited as another reason fewer companies are choosing to go public. The listing fee, the cost of disclosures required by the SEC (both accounting and opportunity costs), the cost of resources required to meet regulatory requirements, the cost of producing quarterly earnings reports, political and societal pressures, and the risks of activist investors are all additional costs public companies may face. Mauboussin argues that these costs can dissuade companies from completing an IPO. In addition to these costs, Ramgopal Venkataraman, Joseph P. Weber, and Michael Willenborg found in their research7 that audit fees rise for an IPO engagement. While an increase in price is to be expected for an IPO engagement due to new and increased responsibilities for the audit team, Venkataraman et al. found that a large portion of the increase in price from an ordinary, post-IPO audit, to an ongoing IPO audit is built in by auditors to provide a cushion for increased exposure to litigation. These inflated fees represent another cost to companies going public, providing additional evidence to support Mauboussin’s argument.
For more information on the costs of going public, read the following article: The Costs of Going Public
Selling out – While the number of U.S. IPOs has been on the decline since the 1990’s, the value of publicly-listed companies has been moving in the opposite direction. Jay Ritter of the University of Florida believes that there is less value in being a small, independent company than in being part of a large company. This could explain the increase the U.S. has seen in strategic acquisitions of small growth firms by large companies such as Amazon, Google, and Intel, via their venture capital arms. Many companies that would have been prime candidates for an IPO in recent years were acquired by larger firms. Several great examples of acquisitions that stymied potential IPOs are the AppDynamics acquisition by Cisco Systems, Instagram and WhatsApp by Facebook, and Nest and Waze by Alphabet (formerly Google). Ritter also argues that the optimal scale of a company has increased in recent years, also resulting in an increase in mergers and acquisitions, and in return, fewer IPOs.
Liquidity and administrative costs – Davidoff Solomon argues that IPOs are down because the demand for smaller offerings has declined as a result of mutual funds seeking greater liquidity and lower administrative costs. Solomon believes funds have recognized that one large offer requires a smaller headcount than many small offers, while the payout of one large offer is equal to, or even larger than, the aggregate payout of many small offers. This theory aligns well with the changing number and size of IPOs seen over the last two decades; according to the Wall Street Journal, 624 IPOs raised $38 billion in 1996, while 291 IPOs raised $96 billion in 2014. According to this theory, because investors have increased their demand for larger offerings (and decreased demand for smaller offerings), the cost of taking a small company public has risen disproportionately to other financing options. This results in fewer companies going public overall, and a larger average offering value for those that do go public.
Efficient private market – One reason companies choose to go public is to raise additional capital, as the public market has historically been one of the most efficient places to obtain needed capital. Although public markets are still an efficient way to raise funds, some argue that changes in the private markets have led to companies waiting longer to go public, or choosing not to go public at all. The reason for this change cannot be explained by one factor alone, but is likely the result of many factors. The commonality among these factors is that the onus of going public is greater than any possible loss of capital allocation efficiency as a result of obtaining private funding. The following are several factors that have likely influenced the rise of private funding:
- Historically low interest rates have provided some companies with the opportunity to obtain loans from banks at extremely low cost, while still maintaining full ownership and avoiding the public scrutiny that comes with being a publicly-listed company.
- The JOBS Act of 2012 has made it much easier for private companies to obtain funding from the private markets. Title III of the JOBS Act (passed in 2015) was particularly impactful, permitting much greater investment flexibility for non-accredited investors.
- Low returns in the stock market urged investors to turn to venture capital and growth equity to get higher returns, creating an increased supply of capital to startups and lowering the cost of financing for early-stage companies.
Rebalancing – A study put out by EY reveals that more than half of the decline in IPOs since ’96 is a result of failed post-dot-com bubble businesses. Though many IPOs occurred in the 90’s, many of the businesses failed and were subsequently delisted. While half of the decline is not explained away by failed dot-com era business, this finding provides strong support for the argument that the decline in IPOs is not a sign of weakness in the U.S. capital markets, but is more likely, at least in part, a rebalancing or course correction in public markets. In the same study, EY found that the largest 1% of publicly-listed companies make up 29% of the total market capitalization, and that only 140 companies represent over 50% of U.S. market cap. These numbers together paint a picture of strong capital markets, which seems to fly in the face of other arguments claiming the decline in U.S. IPOs may signal a weakening capital market.
Davidoff Solomon also agrees with this theory, suggesting that IPOs are normalizing, as IPOs were high in the 90s and are now correcting to the levels seen in the 70s and 80s.
IPO Waves – Similar to the theory of rebalancing, IPO waves explain the change in levels of IPOs by examining the market conditions at the time of IPO. L’ubos Pastor and Pietro Veronesi argue in their paper titled Rational IPO Waves that the movement in levels of IPOs each year vary by “expected market return, increases in expected aggregate profitability, or increases in prior uncertainty about the average future profitability of IPOs8.” Pastor and Veronesi find that the rise of IPOs is preceded by an upswing in market returns, and is followed by a decline in market returns. This evidence points to the fact that IPOs follow a natural economic trend that reflects the current state of perceived market strength.
There is no one reason that companies choose to—or not to—go public, and there is strong evidence for and against each of the theories listed above. Because there is no universal answer to the question “should we take our company public?” every company must determine what is right for them. Regardless of which theory is correct, the declining number of IPOs has resulted in certain implications for all companies:
- Taking a company public is not always necessary for continued growth and success. With improved access to private capital, successful companies that want to maintain control and decision-making power have the option to do so without having to fear that their funding options will dry up. For more information on other growth and financing options beside an IPO, read the following article: Alternatives to an IPO.
- Taking a company public means more now than ever before. With the rise in administrative and regulatory costs of being a public company over the last 10-15 years, successfully taking a company public carries a great deal of weight. Though many large, thriving companies have remained privately owned, the decline in IPOs and the rise in the average market cap of public companies has made a successful IPO an even bigger deal now than in times past.
- With the decline of IPOs in the U.S. has come a rise in other financing options. Having a thorough understanding of all the available financing options is more challenging than it has been in the past, and may be more important as well. The financing landscape has changed in recent years as crowdfunding, venture capital, angel investors, private equity, corporate venture firms, mutual and hedge funds, commercial bank loans, and venture debt firms have grown and changed. Each financing option brings unique benefits and challenges to a growing company.
As access to these forms of financing has increased in the past few years, their popularity has also grown. It is important to be certain you are making the right financing decisions to achieve your firm’s goals, rather than just following recent trends. Although IPOs have become less common in recent years, a public offering may still be the right path for your company.
For more information on the different types of startup financing and related issues, check out the following articles:
- Overview of Startup Financing
- Types of Startup Investors
- The Stages of Startup Investing
- Venture Capital
As a vital part of the United States economy and of individual retirement plans, the health of the U.S. IPO market is important to understand. Fear of red tape and its associated costs, selling out, liquidity and administrative costs, efficient private markets, and a market rebalance are all possible explanations for the declining number of IPOs in recent years. Whatever the actual cause of this decline in IPOs, it’s important to understand the trend and the corresponding implications for you and your company. For more information on deciding whether going public is right for your company, read the following article: IPO Advantages and Disadvantages.
- CFA Institute Research Foundation: Carsten Burhop and David Chambers – “Initial Public Offerings: A Historical Overview”
- University of Florida: Jay Ritter – “Initial Public Offerings: Updated Statistics”
- SEC – “NASD Rulemaking: Order Approving a Proposed Rule Change to Permanently Expand the NASD’s Rule Permitting Market Makers to Display Their Actual Quotation Size”
- SEC – “Trade Execution: Rules Your Brokerage Firm Must Follow”
- SEC – “Electronic Communication Networks (ECNs)”
- WSJ – “Many Reasons for the Decline in IPO Numbers”
- NYT; Davidoff Solomon: professor of law at Berkeley – “A dearth of I.P.O.s, but it’s not the fault of red tape”
- EY – “Looking behind the declining number of public companies: An analysis of trends in US capital markets”
- Michael Mauboussin – “The Incredible Shrinking Universe of Stocks”
- The Economist – “Why the decline in the number of listed American firms matters”
- The Quote Rule requires specialists and market makers to provide quotation information. The quote information the specialist or market maker publishes must be the best prices at which he is willing to trade (the lowest price the dealer will accept from a customer to sell the securities and the highest price the dealer will pay a customer to purchase the securities). A specialist or market maker may still trade at better prices in certain private trading systems, called electronic communications networks, or ECNs, without publishing an improved quote. This is true only when the ECN itself publishes the improved prices and makes those prices available to the investing public. The Quote Rule ensures that the public has access to the best prices at which specialists and market makers are willing to trade—even if those prices are in private trading systems. – https://www.sec.gov/fast-answers/answerstrdexbdhtm.html
- Electronic Communications Networks (ECNs) are a type of alternative trading system (ATS) that trade listed stocks and other exchange-traded products. Unlike dark pools, another type of ATS, ECNs display orders in the consolidated quote stream. As ATSs, ECNs are required to register with the Commission as broker-dealers and are also members of FINRA. To place orders directly with an ECN, a person must be an ECN subscriber. Typically, only broker-dealers and certain institutional traders are permitted to become ECN subscribers. Individual investors must have an account with a broker-dealer subscriber to place an order on an ECN. An execution occurs when the price of a buy order and the price of a sell order intersect on the ECN. – https://www.sec.gov/fast-answers/answersecnhtm.html
- An alternative trading system is one that is not regulated as an exchange but is a venue for matching the buy and sell orders of its subscribers. https://www.investopedia.com/terms/a/alternative-trading-system.asp#ixzz52gbLjaVI
- A set of rules passed by the Securities and Exchange Commission (SEC), which looks to improve the U.S. exchanges through improved fairness in price execution as well as improve the displaying of quotes and amount and access to market data.
- The Jumpstart Our Business Startups Act, or JOBS Act, loosens restrictions on capital raising for small businesses, such as allowing them to go public with less than $1 billion in annual gross revenue and giving more legitimacy to the practice of crowd-funding (where firms can solicit publicly for investments). Read more: Jumpstart Our Business Startups Act (JOBS)
- Small and midsize enterprises are businesses that maintain revenues, assets or a number of employees below a certain threshold. Every country and economic organization has its own definition of what is considered a small and medium-sized enterprise.
- Ramgopal Venkataraman, Joseph P. Weber, and Michael Willenborg (2008) Litigation Risk, Audit Quality, and Audit Fees: Evidence from Initial Public Offerings. The Accounting Review: September 2008, Vol. 83, No. 5, pp. 1315-1345.
- Ľubos Pastor and Pietro Veronesi (2005) Rational IPO Waves. The Journal of Finance: August 2015, Vol. 60, Iss. 4, pp. 1713-1757.