Abstract
Most analyses of small firms’ decision to seek outside equity financing and the conditions thereof concern private firms. Knowledge of the risk and return of entrepreneurial ventures for outside investors is consequently limited. This paper attempts to fill this gap by examining the Canadian context, where small and medium-sized enterprises (SMEs) are allowed to list on a stock market. We analyze seasoned equity offerings launched by SMEs over the last decade. These public issuers can be considered low quality firms with poor operating performance. Managers issue equity before a large decrease in operating and stock market performance. Individual investors do not price the stocks correctly around the issue and incur significant negative returns in the years following the issue. This is particularly true for constrained issuers. We confirm that entrepreneurial outside equity attracts lemons and that individual investors cannot invest wisely in emerging ventures. Probably as a consequence of individual investors’ lack of skill and rationality, the cost of outside equity financing of Canadian public SMEs is abnormally low.
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Notes
Brown et al. (2006, p. 203) study a sample of Australian SEOs including small issuers, but the mean total assets of the firms in their sample are $617.6 million, and their study is not dedicated to SMEs exclusively.
Lemmon and Zender (2009) provide a good review of the tests between the POH of financial structure and its challenger, the Static Tradeoff Theory.
Public firms’ managers should have already ceded control during the IPOs. In Canada, however, the majority of SMEs go public through a reverse merger (Carpentier et al. 2008). This backdoor listing method does not imply sharing control with the public. By comparison, all SEOs entail sharing of control.
In the classic universe of the US studies, small firms are those listed on the NASDAQ; they hardly correspond to the conventional definition of SMEs. The Advisory Committee on Smaller Public Companies of the SEC (2006) defined a small cap company as a public company with equity capitalization of approximately US$128 million to US$787 million. Companies with a market capitalization lower than US$128 million are defined as microcap companies.
From 1980 to 1996, large institutional investors in the US showed increased demand for the stocks of large companies and decreased demand for those of small companies (Gompers and Metrick 2001). SMEs are generally not capitalized enough to attract institutional investors that invest in SMEs by providing funds to venture capital firms.
In the US, these issues are relatively rare corporate financing events, according to Eckbo et al. (2007, p. 359). The authors report an average number of 552 SEOs per year during the 1993–2003 period. We estimate an average of 260 SEOs per year in Canada, a market whose size is generally considered to be one-tenth of the size of the US market. In Canada, SEOs are relatively more frequent events than in the US.
The definitions are on line at: http://ec.europa.eu/enterprise/enterprise_policy/sme_definition/index_en.htm.
The use of the gross proceeds is provided by the Financial Post database for approximately 33% of issues. We conducted an in-depth analysis of the prospectuses, notices and financial statements to fill the gaps. However, most of the information on the issues launched before the inception of SEDAR, in 1997, cannot be obtained, and the use of gross proceeds is not available for 12.42% of the issues.
The S&P/TSX SmallCap Index considers only the firms not included in the main index, with a market capitalization in excess of CAN$100 million. The median market capitalization before the SEO in our sample is CAN$22.26 million.
Several firms delist in the years following the SEO: some delist following a merger, while others do so for negative reasons. The performance statistics for the whole sample reflect this reduction in the sample size. Even if we get the main accounting data, operating income before depreciation is not available in each case, explaining the small sample variation in Panel B. In some cases, we cannot estimate the ROA of comparable firms. This explains the small variation in the sample in Panel D.
A large body of literature is devoted to the estimation of long-run performance (see Eckbo et al. 2007, for a review); this is a complex problem we cannot address extensively here. We simply assess whether similar results are obtained when the calendar-time method with Fama-French risk factors is used. This is the case, but we present neither the methodology nor the results, to keep the article at a manageable length.
When we estimate the abnormal return following SEOs, we do not consider the discount attached to the new shares. The return is thus estimated from the point of view of existing shareholders.
Venture issuers must file a business acquisition report if the size of the acquired business exceeds 40% of the size of the acquiring company (20% for non-ventures), and a venture issuer needs only to disclose 1 year of audited financial statements of the acquired firm. Non-venture issuers should disclose 3 years of financial statements. Venture issuers listed in British Columbia are not required to file such a report. Sarra (2009) provides an analysis of the treatment of junior issuers in Canada, and a list of the regulatory differences between venture and non-venture issuers can be consulted on the Canadian Securities Administrators website, at: http://www.gov.ns.ca/nssc/docs/cdbrochure.pdf.
See Take your business to the next level: Inside Success, TSXV brochure, on line at http://www.tmx.com/en/pdf/TSXVentureSuccessStories.pdf. Boosted by resources prices, the Venture market provides a total return of 33.5% in 2006. The index return for this market was −4.9% in 2007 and −71.9% in 2008.
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Carpentier, C., L’Her, JF. & Suret, JM. Seasoned equity offerings by small and medium-sized enterprises. Small Bus Econ 38, 449–465 (2012). https://doi.org/10.1007/s11187-010-9271-x
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DOI: https://doi.org/10.1007/s11187-010-9271-x
Keywords
- Financing decision
- Equity offerings
- Small business
- Long-run performance
- Cost of equity
- Financial constraints