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Financing Best Practice

IPOs in Emerging Markets

by Janusz Brzeszczynski

Executive Summary

Introduction

An initial public offering (IPO) is the sale of a company’s shares to the public for the first time, leading to a stock exchange listing. This process is known also as a public offering, or “going public.”

The main reason for IPOs is the need for fresh capital to finance various business activities, such as the development of new products or expansion into new markets. Most IPOs are launched by relatively small but dynamic companies, which grow too fast to be financed only in traditional ways such as by bank loans. Nevertheless, many big privately owned companies also decide to become publicly traded.

Decisions about an IPO are predominantly based on the actual capital requirements and the expansion plans of the management, but the timing of the IPO is very strongly determined by the current macroeconomic environment, business cycles, and stock market phases.

IPOs are considered to be risky for both the issuers and the investors. The issuers may miscalculate the value of the company and choose the wrong time to go public. In this event, the amount of capital raised from the IPO will be less than expected, and control of the company may be lost by diluting the shares of previous stockholders in the new ownership structure after the IPO. However, when an IPO is successful, a company can raise more capital than anticipated, and the original stockholders may still be able to control the company.

As for the risks faced by the investors, first, they may make errors in assessing the company value, and second, it is very difficult to predict how the share price will behave once the company is listed on the stock exchange. Investors normally have access only to limited historical data, which makes the valuation and the appraisal of the firm’s financial situation rather difficult. Moreover, the majority of IPOs are companies that are experiencing a transitory growth stage. This creates even more uncertainty about their value in the future. Last but not least, the stock market before and after an IPO may behave in an erratic way and exhibit high volatility, which in a short period of time may lead to either unexpected profits or unexpected losses.

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Further reading

Articles:

  • Beck, Thorsten, Asli Demirgüç-Kunt, and Vojislav Maksimovic. “Financial and legal constraints to firm growth: Does firm size matter?” Journal of Finance 60:1 (February 2005): 137–177. Online at: 10.1111/j.1540-6261.2005.00727.x
  • La Porta, Rafael, Florencio Lopez-de-Silanes, and Guillermo Zamarippa. “Related lending.” Quarterly Journal of Economics 118:1 (February 2003): 231–268. Online at: dx.doi.org/10.1162/00335530360535199
  • Rajan, Raghuram G., and Luigi Zingales. “The great reversals: The politics of financial development in the 20th century.” Journal of Financial Economics 69:1 (July 2003): 5–50. Online at: dx.doi.org/10.1016/S0304-405X(03)00125-9
  • Shleifer, Andrei, Rafael La Porta, Florencio Lopez-de-Silanes, and Robert W. Vishny. “Legal determinants of external finance.” Journal of Finance 52:3 (July 1997): 1131–1150. Online at: www.afajof.org/journal/jstabstract.asp?ref=11724

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