A basic question in finance asks to what extent capital should be provided to firms beyond current investment needs in anticipation of funding future investment opportunities. Up front funding lowers a firm’s financing costs by reducing transactions costs associated with subsequent trips to the capital market.
If, however, future investment opportunities fail to materialize, funds provided up front constitute a free cash flow that managers can squander on other negative net present value projects [Jensen (1986)]. Thus, while sequential financing (providing funding in stages) increases issuance costs, it reduces the free cash flow agency costs of overinvestment. In this study, we examine the extent to which the sequential financing problem can explain the timing of capital infusions in a sample of newly public firms.
The staging of capital infusions is almost universally used by venture capitalists where private startup companies are characterized by severe information asymmetry. In his classic study of field evidence, Sahlman (1990) notes that “The most important mechanism for controlling the venture [by the venture capitalist] is staging the infusion of capital.” However, there is also evidence of financing arrangements in public equity markets that similarly address the sequential financing problem. Unit IPOs, where warrants are bundled with common stock, pre-commit firms to sell more equity in the future at the warrant price [Schultz (1993)].
If future investment projects fail to materialize, the stock price will not increase enough to allow exercise of the warrants and firms do not receive additional funds. Mayers (1998) demonstrates how convertible bonds, as opposed to sequential financing with straight debt, can save on issue costs and still mitigate the overinvestment problem. When future investment projects are valuable, conversion leaves up front funds in the firm; alternatively when future projects are not profitable, conversion does not take place and up front funds are returned to investors. In a broad sense, unit IPOs and convertible debt can be viewed as “milestone staging” where funds are provided when certain goals, as reflected in the stock price, are met. What we examine in this study is “round staging” where less funding is raised at the time of the IPO to shorten the time to the next financing round.
Our investigation of public market staging is motivated, in part, by evidence suggesting that there is a broad heterogeneity with respect to which newly public firms return to the capital market for additional funding (see, for example Helwege and Liang (1996) and Jegadeesh, Weinstein, and Welch (1993)) Explanations of this heterogeneity include the signalling hypothesis in Allen and Faulhaber (1989), Chemmanur (1993), Grinblatt and Hwang (1989), and Welch (1989), the market-discovery pooling explanations in Allen and Faulhaber (1989) and Welch (1989), the market-feedback hypothesis in Jegadeesh, Weinstein, and Welch (1993) and, more broadly, market-timing explanations that are driven by post-IPO market conditions (sentiment, market liquidity, etc.) and/or aggregate levels of asymmetric information (e.g., the windows of opportunity hypothesis (Bayless and Chaplinsky (1996))). In contrast to these explanations, the public market staging hypothesis we investigate predicts that important determinants of the time to the first post-IPO financing are known prior to the time of the IPO.
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