SME Financing in Canada, 2003 — Part IV: Profile of Risk Capital Financing

4. Initial Public Offerings (IPOs)

As mentioned earlier, firms typically go through various stages of financing during their life cycle. VC financing, which serves as a bridge between the informal financial sector and the public capital markets, is only a transitional phase in financing. VC will likely be more efficient in the presence of a strong informal capital market that screens, evaluates and finances new deals and strong formal capital market that provides good exit potentials, preferably through an IPO.¹²¹ As research has found, an efficient IPO mechanism offers the prospects of a profitable exit for early-stage investors and therefore encourages investment in innovative, high-growth-potential firms.¹²²

This section examines a recent SME Financing Data Initiative study on the performance of SMEs that issued IPOs in Canada between 1991 and 2000. The study revealed the following:

• Public financing is a key stage in the development and growth of SMEs, especially that of knowledge-based SMEs. After raising capital stock exchanges, SMEs may have ongoing access to a regular source of capital. IPOs also provide an attractive exit for venture capitalists, who in turn provide equity capital to small and growing companies.
• Canada has an active IPO market, but one with marked weaknesses: Canadian IPOs tend to be smaller than American IPOs, many Canadian firms go public too early and their success and survival rates tend to be very low.
• IPOs in Canada tend be associated with high costs, which are especially onerous for smaller businesses. Moreover, Canadian IPOs tend to be under-priced, which seems to have a significant impact on SMEs' competitiveness.

IPOs in Canada: Size, Performance and Cost

Different kinds of shares are offered in a typical IPO: Common shares, which are the most frequently offered, represent part ownership and voting rights. Common share owners may receive dividends, but only after preferred share owners. In the event of company liquidation, common share owners are the last to claim any of the company's asset Restricted voting shares are a class of common shares whose voting rights are limited Preferred shares grant a fixed dividend to their holders before any dividends are paid on common shares, and a stated dollar value per share in the event of company liquidation, but they don't usually come with a vote

4.1 Size

Canadian IPO market is comparable to US regional markets
Canadian IPOs tend to be very small transactions. Between 1996 and 2000, the average value of IPO transactions in Canada was $2.5 million; between 1995 and 1999 the average was $131 million in Germany, $74 million in France, $93 million in the UK and $84 million in the US Moreover, compared to the UK, France or Germany, Canada has had more small companies undertaking small transactions (in size and value). In fact, 90 percent of the companies that issued IPOs over the 1990–2000 period in Canada would have been considered too small (as measured by transaction value) to be covered under the American Securities and Exchange Commission regulations, or to be listed on national stock exchanges such as the NASDAQ or the New York Stock Exchange.

The Timing of IPOs: "Hot" and "Cold" Markets As indicated in Figure 62, companies tended to undertake IPOs in waves. The biggest waves were in 1993–1994 and 1996–1997, when the markets were particularly bullish, 1997 being the record year for this activity. Usually, companies choose to register an IPO at a time of "hot" market activity to maximize their share prices. Investors tend to be more interested in IPOs during bullish stock market periods. Unfortunately for companies, share under-pricing tends to be more of a problem during these periods as well.

4.2 Survival rate

Canadian firms have low post-IPO survival rate
Very small issues by small or very small companies (under $1 million in net assets) with very short track records, have an extremely small chance of succeeding. Of the 153 companies with gross proceeds under $1 million that launched an IPO between 1991 and 1995:

• 53 percent were unsuccessful, either because they were written off, had negative net assets or ended up with net assets worth less than their transaction values
• 28 percent survived over five years and had a positive book return with net assets worth more than the proceeds of the IPO
• Only 6 percent survived over five years with net assets exceeding $10 million, and these could be considered real successes

Similarly, of the 95 companies with gross proceeds between $1 million and $5 million:

• 28 percent had either negative net assets or assets worth less than the gross proceeds
• 34 percent survived over five years and had a positive book return with net assets worth more than the proceeds of the IPO

Finally, of the 27 companies with gross proceeds between $5 million and $10 million:

• 40 percent had either negative net assets, or assets worth less than the gross proceeds
• 19 percent survived over five years and had a positive book return with net assets worth more than the proceeds of the IPO

Over the 1991–2000 period, more public companies disappeared from the Canadian stock exchanges than were added; the number of companies listed on Canadian stock exchanges declined by 5 percent, from 4342 to 4124, in spite of the 1891 IPOs.

4.3 IPO Cost

Going public is less expensive in Canada than in the US
The direct costs of issuing an IPO are determined by regulatory costs — including the preparation of a prospectus, the payment of fees and the work of various professionals — and the commission paid to an underwriter. Regulatory costs are more onerous for small firms than for larger ones. The commission paid to the underwriter is a percentage of revenues raised by the share offering.

Size being equal, the direct costs of issuing an IPO in Canada are lower than those in the US and, on average, the underwriter's commission is less in Canada than the US standard of 7 percent (Table 27). However, these costs remain burdensome, especially for SMEs.

Paradoxialy, junior-capital-pool companies — for whom the IPO process is meant to be simplified and cheaper — actually pay a higher percentage of the transaction value to issue an IPO (23 percent) than do traditional SMEs of comparable size (16 percent).

Additional costs: the under-pricing of initial shares
The underpricing of initial share offerings constitutes an additional cost for all issuing companies, but one that becomes a serious matter for newly public SMEs. These costs affect, and perhaps determine, the ultimate success or failure of the company. Moreover, the smaller the company is when it goes public, the bigger the underpricing problem appears to be.

Figure 63
Number and Value of Canadian IPOs, 1991-2000

The problem in Canada may be due to the lack of competition between brokerage houses, particularly since 70 percent of industry revenues are earned by seven bank-owned firms, including all six of the largest banks. Other factors contribute to share under pricing, including:

• the lack of hard negotiating skills or power among many SME managers, since the initial price is set by underwriters
• book-building, which is the method brokers use to calculate initial orders
• the unduly powerful influence of institutional investors

These factors are further explained in the attached box.

Share underpricing occurs when the value of a company is underestimated as a reflection of the share price. According to recent research, initial shares are frequently under-priced. Moreover, underpricing tends to be more of a problem in a "hot" market than in a "cold" one. Ironically, more SMEs launch IPOs during hot markets in an attempt to maximize their share prices.

 

Table 27 — IPO Costs by Issue Size, 1997–1999

Size of Issue (U.S. $ Millions)	Number of IPOs	BROKER COMPENSATION (%)	Other Expenses (%)	Total Direct Costs (%)	Under Pricing (%)
CANADA
1.0–9.9	53	8.12%	7.86%	15.98%	30.61%
10.0–49.9	49	6.14%	3.31%	9.45%	11.30%
50.0–99.9	10	6.00%	2.00%	8.00%	10.76%
100 and over	16	5.53%	1.75%	7.28%	8.88%
Average		6.88%	4.90%	11.78%	18.95%
Weighted average by size		5.35%	1.84%	7.19%	5.11%
UNITED STATES
1.0–9.9	119	9.29%	8.70%	17.99%	9.05%
10.0–49.9	532	6.93%	3.70%	10.63%	26.15%
50.0–99.9	300	6.88%	2.12%	9.00%	55.57%
100 and over	237	6.09%	1.20%	7.29%	67.19%
Average		7.00%	3.30%	10.30%	37.50%
Weighted average by size		5.79%	1.43%	7.22%	38.38%

The direct costs of Canadian primary issues are from final prospectuses that were not available on the SEDAR until 1997. The direct costs of US primary issues are from final prospectuses available on the SEC site.

Source: Carpentier, Kooli, Suret, 2003.

4.4 Conclusion

Determinants of Success and Failure of an IPO Size: companies whose transaction values are less than $10 million are less likely to be successful. As previously discussed, over a five-year period following the initial issue, companies of this size tend to lose half their value, once market fluctuations are accounted for. Issue periods: market cycles also play a role. Companies tend to under-perform if they launch their IPO during a "hot" market cycle. Sector: under-performance varies considerably from sector to sector. Financial services companies performed better than technology or natural resource-sector companies in the first five years after an IPO. Analyst attention: analyst interest is critical to a company's ability to raise equity capital and perform well in the market. According to the study, it is probable that analysts do not pay sufficient attention to SME IPOs in the belief that they are not sufficiently capitalized to interest institutional investors. Institutional investors: institutional investors can affect SME IPOs negatively, as they hold immense power in the process of negotiating the initial share price and, therefore, in affecting its under pricing. Moreover, empirical evidence shows that IPOs are oversubscribed to institutional investors, and that individual investors have problems obtaining securities at the offering price, which limits the amount of liquidity for small capitalisation securities, and can contribute to the lack of analyst and broker interest in small capitalisations, due to low transaction levels. Book-building: the method by which the underwriter establishes the initial share price seems to disadvantage SMEs. Underwriters and company managers present a "road show," which is the presentation of the company, its products or services, market, and perceived value, to institutional investors and interested brokers who will in turn sell the company's shares to individual investors. The underwriter then gauges investor interest and thereby establishes the demand curve for the company's shares. According to the study, book-building tends to favour institutional investors, who are inclined to dismiss SMEs.

Stock markets: unfriendly places for SMEs
The low survival rate of SMEs that use the IPO process signals major problems in the operation of the primary issues market. As noted above, only 6 percent of the smallest companies (under $1 million in transaction value) show the potential, after five or ten years, of growing into large businesses.

American results are similarly disappointing. Success rates have been very low for companies whose transaction value is between $1 million and $20 million (comparable to most Canadian IPOs) and which raise public funds through the Small Corporate Offering Registration (SCOR). Available data suggest that few of these companies grow sufficiently to issue shares on national exchanges such as the NASDAQ or NYSE.

In a dynamic risk capital market such as Canada's, there is a widespread belief that in an active market, venture-backed companies will naturally move from small to medium size before going public.

However, the study indicated that, while Canada has a very active risk capital market, firms tend to go public too early, perform poorly and have very low success rates (or survival rates). This situation signals a fundamental problem with respect to SMEs' readiness to undertake IPOs.

The dysfunctions in the small issues market (low survival rate, high costs, share underpricing and poor medium-term return) are symptomatic of problems encountered by small and medium-sized growing firms in their pre-IPO stage of financing. Empirical evidence suggests a need to expand the Canadian VC market's capacity to support more venture capital financing that would, in turn, support more IPOs. This would improve the VC market's capacity to cope with growth and would stimulate institutional investors' participation in the VC market. The result would be greater VC fund specialization and increased competition for investment deals, which could lead to higher company valuations, larger investments and more capital for IPOs. This should be supported, however, by measures that would allow IPOs to be deferred until businesses have a reasonable chance of survival. Ultimately, small Canadian firms could grow and exploit the full benefits of their innovations.

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121. In an initial public offering, a company raises capital by issuing shares to investors and subsequently becoming listed on a stock exchange. In these transactions, shares are sold to investors to provide equity capital to the company in return for company ownership.

122. Allan Riding, Financing Entrepreneurial Firms: Legal and Regulatory Issues. Research paper produced for the Task Force on the Future of the Canadian Financial Services Sector, 1998.

123. Cecile Carpentier, Maher Kooli, Jean-Marc Surêt, Université Laval, 2003. Les Émissions Initiales au Canada: Statut, Anomalies et Dysfonctions.