EVALUATING THE COSTS OF RAISING CAPITAL THROUGH AN INITIAL PUBLIC OFFERING

This article provides an empirical analysis of the costs of going public based on a sample of 1852 offerings during 1977-1987. The sample includes 1556 firm-commitment issues and 296 best-efforts issues. Three components of the cost of going public are examined: (1) direct cash expenses such as legal and accounting costs; (2) investment bank's commission; and (3) costs resulting from the investment bank practice of pricing initial public offerings below their market values. All of the cost components are significantly higher for best-efforts offerings than for firm commitments. In fact, best-efforts offerings are more than three times as expensive (on a percentage basis) than are firm commitments. In addition, there are marked economies of scale in the process of going public. The total costs of going public were 40% of gross proceeds for the smallest firm-commitment issues but only 15% for the largest. In dollar terms, we estimate that a typical, small-firm commitment offering of $2.5 million will cost approximately $800,000 (32% of gross proceeds), whereas a large issue of $25 million will cost approximately $4 million (16% of gross proceeds). The issuing firm's earnings, as well as the type of investment bank underwriting the issue, were also important cost determinants. The primary implication of our results for entrepreneurs is that it is quite expensive to attempt a public offering prematurely. The "marginal" issuer with a small capital requirement and a poor earnings history will be at a large cost disadvantage to more-established firms. More specifically, we advise that the firm have capital requirements of at least $10 million and positive operating income before attempting a public offering. Postponing a public offering until the issue will be well received by investors and investment banks is likely to be worth the wait. Until that time. alternative sources of funds will be more cost-effective. © 1991.