Energy Technology IPOs: Linking Financial Markets and Sustainable Development

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1 Partnerships for Sustainable Development November th International Conference of Greening of Industry Network Hong Kong Energy Technology IPOs: Linking Financial Markets and Sustainable Development William H. Moore, Jr. Dr. Rolf Wüstenhagen The Institute for Economy and the Environment University of St. Gallen Tigerbergstrasse 2 CH-9000 St. Gallen, Switzerland Tel , Fax IPO_GIN04/$FILE/Moore_Wuestenhagen_GIN04.pdf

2 Abstract This paper presents partial results from research being conducted to understand the link between financial markets and sustainable energy development, with an emphasis on electricity. The research explores the process by which young sustainable energy technology companies execute initial public offerings on major stock markets worldwide. Space considerations limit this paper to analysis of key research questions for ten energy technology companies that were take public in the US between 1997 and Results are primarily descriptive. Future papers will discuss findings with respect to a broader range of research questions and for a larger sample group that cuts across multiple countries and provide additional underlying theory. In this paper we show that ten energy technology companies exhibit many characteristics common to initial public offerings. More importantly, we show that between 1997 and 2000 these ten energy technology companies alone raised almost $624 million in capital via initial public offerings, but that over $643 million was left on the table. Finally we discuss the tendency for energy technology companies taken public to be relatively mature, float less than one-third of their total shares, finance pre-initial public offering growth with equity, use underwriters with the best reputations, incur offering expenses in line with industry norms, perform well in the short-term but not the long-term, and to be risky investments relative to a market benchmark. The small sample size restricts our ability to generalize beyond the group studied. Key Words: Initial Public Offerings, Sustainable Energy, Sustainability Investments, Sustainable Development, Venture Capital 2

3 Introduction A boom in the amount of energy venture capital investing and the number of initial public offerings ( IPOs ) began in the early 1990s and carried through into the early 2000s. The boom was facilitated by a series of specific events and several general trends that precipitated the need for change in the electricity value chain and then facilitated the first change efforts. A wide range of new energy technologies emerged commercially, addressing issues all along the electric power value chain. The worldwide level of energy technology venture capital investing and initial public offerings soared, relative to historical levels, and in line with the same changes experienced in many financial markets. 1 Most IPO statistical studies aggregate industries and test hypothesis using large samples. A wide range of characteristics, structures, tendencies, levels of activity, and the effectiveness of IPOs at this aggregate level have been studied in detail. Few studies, however, have looked at specific economic sectors. The electric power business is critical to economic development and it is likely that transition from the current to a more sustainable technological configuration will take place in a significant way only with the help of significant investment in new energy technologies. Some of that investment must be provided to relatively high-risk activities via venture capital and IPOs. The lack of information about energy technology IPOs, their unique characteristics, and relationship to venture capital may inhibit investment activity in this important industrial sector. The research project s primary purpose is to understand the link between financial markets and sustainable development by looking at why energy technology companies are taken public, determining whether those that have been taken public have been successful and describing the characteristics of energy technology IPOs relative to IPOs generally, including looking specifically at risk and rate of return characteristics. A sample of approximately 75 young energy technology companies that executed IPOs in the US, Canada, Australia and several Western European countries between 1990 and 2003 has been identified. The technical process by which these young companies are taken public is defined by law and stock market regulations. Capital market receptivity, investment banking practices, auditor opinions, investor characteristics and other factors may also significantly influence the process. The study is investigating these factors. The IPO is an important event for sustainable energy technology companies. The IPO allows early-stage investors such as venture capitalists to exit their investments, provides growth capital, extends the universe of sustainable investments for sustainability investment funds and may play a role in attracting larger corporations to the issue of sustainable energy. Additionally, research has shown that a healthy IPO market is a prerequisite to drawing capital to early-stage companies and promoting innovation in any industry. For energy specifically, the absence of capital flowing to these companies may inhibit the innovation process and movement toward a more efficient and sustainable energy future. The study is investigating these relationships. This research will 1 Notwithstanding the upswing in energy technology venture capital and IPO activity, the level of venture capital and IPO activity remained low relative to other sectors. Unlike venture capital and IPOs in general, however, the level of energy technology venture capital and IPOs did not fall significantly in 2003 relative to

4 increase our understanding of energy technology IPOs, and we hope that this information is helpful to all investors interested in making money and facilitating a change in the fundamental way in which electricity is produced, distributed and consumed in the future. Trends and Events Three concurrently occurring global trends and a series of related events precipitated changes in the international electric power business environment, and these changes in turn facilitated a significant increase in energy technology IPO activity between 1990 and A 20-year long bull market in financial markets that peaked and then corrected, spread of the equity culture that brought new investors and a lot of new money into the market, and an increase in the level of investments made into socially responsible investments; Significant growth in personal computer and Internet use that increased the need for better power system reliability and ushered in new technologies that could be used to implement new efficient forms of communication and control; Increased levels of awareness concerning the environment and sustainability and a trend toward treating environmental and social issues as a matter of corporate strategy and not just compliance. Four concurrently occurring electricity sector specific trends and a series of related events also helped precipitate changes in the international power business environment that then facilitated a significant increase in energy technology IPO activity between 1990 and Significant legal, regulatory and market structure changes; Power shortages and widespread outages in all areas of the world that heightened awareness of weaknesses in power system infrastructure and highlighted the need for alternative infrastructure configurations; Fossil fuels coming under increasing pressure because of concerns about negative externalities, supply levels and security; Emergence of green power markets, financial incentives to implement sustainable energy technologies, market based environmental compliance actions, and an increasing trend for electric utilities to include renewable resources in their resource plans. Against this background, the number of energy technology IPOs rose significantly during the late 1990s. Initial Public Offerings The initial public offering is a process in which the equity shares of a privately held company are taken public. The process typically takes between ten and fourteen weeks to complete and the 4

5 issuing firm typically sells percent of its shares to the public. 2 Collectively, the shares taken public are referred to as the issue. The shares of a company, once taken public, are traded on designated public stock exchanges. Three key stakeholders are involved in the IPO process: the firm, the underwriter and the investor. The primary document describing the firm s IPO is the prospectus, a document that goes into considerable detail about the company, industry, market and issue. Some firms are backed early in their lives by venture capitalists and some are not, a factor often influencing certain characteristics of a firm s IPO. Decision to go public Companies go public to raise capital to finance projects, to achieve a desired level of liquidity, to improve the company s image in a way that improves its relationship with customers and suppliers, 3 and to allow early investors to diversify their personal holdings. 4 Balanced against the positive motivating factors are potential disadvantages. Disadvantages include the cost, time, disclosure requirements, and risk of failure associated with an IPO. 5 Additionally, and perhaps most significantly, the public firm, unlike a private firm, will be subject to laws and regulations concerning many aspects of its operations. And, it will be required to publicly disclose intimate details of its daily operations on a regular basis. A company will also consider general contextual factors. These factors include the current state of the economic cycle and general financial climate, the existence of a previously failed IPO, and the lack of financial community expertise needed to accurately assess energy technology possibilities and risks. Within the energy industry specifically, other factors might be considered, including the energy technology sector s green image, dependence on government subsidies as drivers of economic value, the lack of energy venture capitalists that bring companies to the IPO stage and the fact that the capital intensity of early stage energy technology companies means that typical funds raised in the IPO are not necessarily sufficient to meet growth requirements. At the company specific level, the lack of a convincing business model for innovative energy technologies, weak or inexperienced management teams, and questions about the innovative technology itself can also affect the likelihood that a young energy technology company can be taken public. The decision to go public is not without significant implications and once a company goes public, it may reverse course and later go private. In fact, the recent trend has been for an increasingly large number of public companies to go private. The motivations for doing so are numerous. For example, smaller public companies generally struggle to attract the attention of analysts and the cost of doing so may be high. Second, regulatory burdens have increased due in large part to changes brought about by the 2002 Sarbanes-Oxley corporate governance law. Increasing regulatory burdens may increase compliance costs significantly. 6 2 Ritter (1998). 3 Gompers and Sahlman (2002). 4 Daily et al. (2003). 5 Gompers and Sahlman (2002). 6 Business Week, May 24, A Little Privacy, Please pp

6 The IPO process involves three key steps. First, preliminary work is performed including selection of the key contractors needed to plan and execute the IPO. An underwriter, auditor and legal advisors are typically secured at this first stage, and the focus is on preparing disclosures required by government regulators and stock exchanges on which the IPO will subsequently trade. The second key step is marketing, the primary responsibility of the underwriter. The IPO must be presold or taken by the underwriter into his or her own order book. The final step is the actual IPO event, or the day on which the IPO is actually consummated and the new publicly issued shares are traded. Trading activity subsequent to the initial offering ultimately determines the offering s performance. Underwriter selection The first important step in the IPO process is selection of the investment banker or underwriter. Often, more than one underwriter is selected and one of them will act as the lead. The lead underwriter is listed first in the prospectus. The role of the lead underwriter is to advise the issuer, value the company and price shares, coordinate the activities of subordinate underwriters, provide marketing and research, identify suitable investors, consummate the IPO, distribute the shares and provide market support, research, and financial planning advice after the fact. In most cases, the underwriter will be engaged on a firm basis. Under a firm basis arrangement, the underwriter initially purchases all shares at a discount from the issuer on the IPO date then resells the shares at the IPO price through its own distribution channels and subordinate underwriters. The issuer typically evaluates the prospective underwriter s orientation, 7 capability relative to size, market making capability and research commitments after the IPO, industry focus, cost and reputation. The underwriter s reputation and willingness to assign analysts to cover the company post-ipo are two of the most important factors that a firm will evaluate. The underwriter s reputation will influence its ability to sell the issuer s story and the extent to which the issue can be sold close to a market price or if it must be underpriced relative to the market price to compensate for the risk an investor faces. The better the underwriter s reputation, the more willing an investor should be to buy the issue at prices closer to market and chances are that better returns will accrue, tendencies confirmed by research. 8 Underwriters receive fees for their services, usually in the form of a spread between the price they pay the issuer and the IPO price at which they resell the shares. The selected lead underwriter will go through a due diligence process by checking and confirming the company s history, the market, the company s management team, and other relevant factors. The intended use of proceeds from the IPO will also be confirmed. One of the underwriter s primary objectives during the due diligence process is to identify material adverse information about the issuer. This is an important step for the underwriter because they are in effect putting their stamp of approval on the issue to relatively uninformed outsiders who run the 7 An underwriter s orientation will influence to whom the stock is sold. The orientation can be retail, institutional or a combination of the two. 8 Carter and Manaster (1990), Carter et al. (1998), Lange et al. (2001), Megginson and Weiss (1991), and Chen and Ritter (2000). 6

7 risk of being exploited. The underwriter s reputation is a valuable asset that must be protected and leveraged. Prospectus The lead underwriter will eventually produce a prospectus in collaboration with company management, attorneys and accountants and cause it to be filed with the respective regulatory body. The purpose of the prospectus is to fully disclose information relevant to both regulators and investors. That information typically includes a description of the company s operations, product, history, management, and financial situation. Audited financial statements must be included. Creating a prospectus is an iterative process. Each iteration is shared with regulators and potential investors. The first version of the prospectus is referred to as the preliminary prospectus or red herring. Subsequent revisions will be made as additional information is discovered and confirmed during the due diligence process. On the day of the IPO, a final prospectus that includes the offering price is prepared and distributed. 9 Prospectuses follow a fairly standard format. 10 Responsibility for representations made in the prospectus lies primarily with management of the issuing company, although the auditors are liable for material misrepresentations in the financial statements and the underwriters can be held liable for omissions and misrepresentations. The prospectus will also include information about the exchange on which the stock will be listed for trading. Auditor and legal council selection In addition to selecting an underwriter, a firm will select an auditor and lead legal counsel. The auditor is responsible for providing a fairness opinion about financial statements. Legal counsel provides advice with respect to legally required disclosures and compliance and filing requirements. Some evidence exists that firms regularly change auditors just before an IPO based on underwriter recommendations that the firm needed a nationally known firm to sell the issue at the highest price. 11 Studies have been conducted to determine the extent to which auditor switching has occurred and to what extent auditor reputation may affect underpricing. 12 Road show and book building Well before the actual IPO event, but after the registration statement (initial prospectus) is filed, the underwriter and key representatives of the company meet with potential investors to sell the company s story, albeit in a way that does not disclose any more information than what has already been included in the preliminary prospectus. Several investor meetings can take place each day, over an extended period of time and as close to the end of the regulatory review period as is practical. The outcome of the road show is that the underwriter will have built a book of orders that provide an indication of investor interest and the market clearing price at which the shares are likely to sell. The underwriter will use the list of potential customers from this book on the day of the IPO to resell the shares. 9 Bagley and Dauchy (2003). 10 Ibid. 11 Balvers et al. (1988) and Beatty (1989). 12 Ibid. 7

8 Valuation and pricing Another important responsibility of the underwriter is to recommend and negotiate price with the issuer. The lead underwriter values the firm and prices the issue in consultation with management of the issuer, an iterative process as described above. A preliminary valuation is prepared during the underwriter selection process. Higher or lower valuations, however, have not been associated with the probability that a prospective underwriter is retained. 13 Further, valuations are notoriously inaccurate as price predictors of final offering prices. 14 The final IPO price is heavily influenced by results of the book building process. Strong demand for shares in a new company would indicate a higher price relative to weak demand that might indicate a lower price. Usually, an offering range is set after such demand is known. The actual IPO price is set the night before the actual IPO based on one last assessment by the underwriter of demand and market conditions. IPO event Once the prospectus is approved by the regulatory agency the final price for the shares and the number of shares to be sold can be set by the company and the underwriter. Trading in the stock can take place the next business day. Three days after the stock starts trading, the transaction closes. Post-IPO trading Underwriters and regulatory entities restrict post-ipo trading by pre-ipo shareholders. For example, under some regulatory rules, certain stock is restricted and can only be resold into the public market one year after the IPO closes. Lock-up agreements between the underwriter, the issuing firm, and pre-ipo investors may impose restrictions not required by law. For a number of reasons, underwriters may also discourage post-ipo trading by some investors and impose penalties in some situations where post-ipo trading takes place. First, selling by insiders and early investors too soon after the IPO sends negative signals to IPO investors. All else being equal, IPO investors would rather see pre-ipo investors stay the course and put their money where their mouth is, so to speak. Second, underwriters allocate shares to some investors based on representations that they have long-term investment perspectives. Underwriters discourage these investors from selling soon after the IPO is completed. Third, selling too many shares soon after the IPO date may cause downward pressure on the stock price, a situation that underwriters want to avoid. Some trading in the IPO shares is encouraged. For example, buying activity tends to support price increases, a situation that underwriter s encourage. Withdrawn offerings IPOs can be withdrawn before they are completed. There may be various reasons for withdrawing the IPO, including a temporary downturn in the stock market or the market s 13 Smith and Smith (2000). 14 Ibid. 8

9 general interest in IPOs, the need to include additional financial information in the prospectus (a timing problem), material developments that change the company s situation, a change in the firm s management, regulatory questions that need to be addressed, or the inability of the lead underwriter to build an adequate book. 15 Firms may be limited to the time frame within which they can start the process again (6 months in the US). A recently emerging trend is for IPOs to be cancelled because the company is sold before the IPO can be completed, the outcome of the so called dual tracking IPO. 16 IPO activity In the US alone, 6,249 IPOs took place between 1980 and On average, this is roughly one per day. A full range of technology, software, retail, and other types of companies were taken public, most often in biotechnology and software. Stated in 2001 dollars, these IPOs raised a total of $488 billion, or an average of $78 million per IPO. IPO activity was especially heavy in between 1998 and Comparable data on the actual number of energy technology IPOs that have taken place over the last several years does not currently exist, but is being created by the authors. In general, however, a wide range of energy technology companies has been taken public, including technology, production, development and software companies. The companies were taken public on a number of US based and European stock exchanges. The most common exchange to take a company public is the NASDAQ in the US. The Sample and Data Collection Procedures Approximately 75 energy technology company IPOs were executed between 1990 and 2003 in the US, Canada, Australia and the Western European countries that are included in this study, including those representing a wide range of generation, transmission, distribution and end-user technologies. Research, development, production, and commercialization interests are also represented. Our ongoing research focuses on this larger group. For purposes of this paper, however, we selected a smaller sample of ten energy companies that executed IPOs between 1997 and 2000 and that represented a cross-section of sustainable energy technologies. All references in this paper to energy technology companies are with respect to this small group. All ten of these companies were taken public on the Nasdaq National Market in the US, although companies can be taken public on other US and European based stock exchanges and differences between markets do exist. 18 The sample companies were identified by querying industry experts and regulatory agency databases, reviewing industry trade journals, crosschecking against industry trade association membership lists, and reviewing stock market listings. The companies included in the sample group for the analysis in this paper follow in Table Bagley and Dauchy (2003). 16 Wall Street Journal Online, July 23, Many start-ups opt for dual tracking IPO or outright sale. A dual track offering occurs when a company initiates IPO and sale processes simultaneously. Some companies, when valuations are close, may opt for sale rather than IPO because of the inherent risks associated with the IPO process. 17 Ritter and Welch (2002). 18 See for example Ritter (2003). 9

10 Table 1. Sample Company Ticker Symbol Product IPO Date 1 Active Power, Inc. ACPW Power Quality 8/8/00 2 Advanced Power Technology APTI Power Semiconductors 8/8/00 3 AstroPower, Inc. Delisted Solar Modules 2/13/98 4 Beacon Power Corporation BCON Energy Storage 11/17/00 5 Caminus Corporation Acquired Energy Management Systems 1/28/00 6 Capstone Turbine Corp. CPST Distributed Power Generation 6/29/00 7 Evergreen Solar ESLR Solar Modules 11/2/00 8 Millennium Cell, Inc. MCEL Hydrogen Generation 8/9/00 9 Plug Power Inc. PLUG Fuel Cells 10/29/99 10 Power-One, Inc. PWER Power Conversion 10/1/97 Sources: IPO Prospectuses and Notes: IPO date is the first date on which the shares traded. Data collection for the larger study group is ongoing. General information for this limited study was created from annual reports, press releases, articles written about the company in the popular press, and reports in which some discussion of the sample company took place. General information was used primarily to assess the company s fit in the sample and to assign a business type. Context data was collected from published articles, textbooks, regulatory filings, interviews with industry experts, the literature, press articles, and company press releases. Data specific to the IPO was created by drawing facts directly from source documents whenever possible. The source document for IPO data is the IPO offering prospectus. The IPO offering prospectus contains data about shares sold, prices, underwriters, underwriting costs, capital structure and other relevant financial information, auditors, venture capital investors, lead counsel, and key dates. Prospectuses were secured from the U.S. Securities & Exchange Commission website ( company websites, or via direct company request. Equity betas are taken directly from Yahoo provides historical betas in the Key Statistics area of each company. 19 This data was collected on July 7, Methodologically, Yahoo regresses monthly stock price against the S&P 500 using at least 3 years of data. Data used to calculate rate of return was secured from two sources. First, data used to calculate short-term performance (IPO date daily rate of return) was collected from the offering prospectus (IPO price) and Yahoo (first trading day closing price). The rate of return analysis is based on financial modeling procedures outlined in Reilly and Brown (2000). In many cases the data was crosschecked against another source if one was available. Second, data used to calculate long-term performance for both the company and the benchmark index was collected from Yahoo. 19 See for example 10

11 IPO Characteristics A wide range of characteristics of companies taken public has been identified in previous research, 20 including studies that describe factors affecting the decision to go public, characteristics of companies taken public, and certain phenomena related to the IPO process and event. They are, for example: grandstanding, underwriter reputation, IPO pricing, auditor reputation, lead counsel, valuation, venture capital backed/not backed, underwriter expenses, governance, size, underpricing, short-term performance, long-term performance, risk, hot-issue markets, and trading activity. For purposes of this paper, we selected a manageable subset of the characteristics commonly studied and evaluated those characteristics for our sample companies. The literature and preliminary results for several of the key characteristics are described in detail below. General characteristics Table 2 below shows general characteristics of the ten energy technology companies in our sample. Table 2. General characteristics Approx. Company Age at IPO Company (months) Public Float Approximate Capital Structure at IPO Debt Equity Active Power, Inc Advanced Power Tech AstroPower Inc Beacon Power Caminus Corporation Capstone Turbine Corp Evergreen Solar Millennium Cell, Inc Plug Power Inc Power-One, Inc Mean Sources: Company IPO prospectuses and own analysis. Notes: Mean public float is issue value weighted. Debt may or may not include current liabilities or dividends payable. At an average age of 75 months, or approximately six years, energy technology companies tend to be on the older end of the spectrum compared to most companies taken public. 21 Public float, the percentage of a company s total outstanding shares that are taken public in the IPO, varied 20 See for example Barry et al. (1990). 21 For example, Bygrave and Timmons (1992) found that the median age of a company going public was 48 months in a sample of venture capital backed IPOs. Gompers (1996) found the average age of venture capital-backed firms at IPO to be between approximately 55 and 80 months, depending on the age of the venture capital company backing them. 11

12 from 11 to 34 percent, a typical range for IPOs. Finally, energy technology companies tend to be financed almost exclusively with equity during start-up, although some are highly leveraged. The highly leveraged examples in the study group tend to be owner, not venture capital, financed. Underwriter reputation Underwriter s build, protect and leverage their reputation for a number of reasons. First, reputation has value that can be sold in the marketplace and underwriters expect to earn a rate of return on this form of implicit capital. Second, underwriters certify the accuracy of pricing, a role that cannot be played by the company itself. 22 Third, underwriters certify the quality of the IPO. Investor s know that high quality (low risk) IPOs are brought to market by high prestige underwriters. 23 Fourth, the underwriter validates that there are no skeletons in the closet, a process described above as due diligence. High prestige underwriters with the most to lose conduct thorough due diligence. The literature also suggests that underwriter reputation can affect the amount of underpricing. 24 Finally, signaling theory has been used to explain certain IPO tendencies, independent of underwriter involvement. 25 Three methods for ranking underwriter reputation are discussed in the literature. Carter and Manaster (1990) offer a system based on analysis of where the underwriter s name is placed on the tombstone between 1980 and Carter, Dark and Singh (1998) updated these rankings for the period 1985 through 1991, and these rankings can be matched with the timing of specific IPOs. Johnson and Miller use an alternative classification system 26 and Megginson and Weiss (1991) use the underwriter s relative share of underwriting business as a proxy for their reputation. Jay Ritter provides and adjusts Carter and Manaster and Carter, Dark, and Singh rankings on his website for the two reported time periods, 27 as well as extending the rankings into the time frame. Our study uses Ritter s rankings. Ritter s adjusted Carter-Manaster rankings rely on the fact that underwriters are shown in the filed prospectus along with the number of shares that they underwrite. Clustered groups of underwriters are often shown. The higher the underwriter is placed in the list and within a cluster and the more shares they underwrite the higher is their prestige. By making a slight adjustment to the original Carter-Manaster 0-9 scale, Ritter assigns the highest rank, a 9.1, to underwriters that always appear first in the highest cluster. Underwriters appearing lower in the list or cluster are assigned lower rankings, but never a rank lower than 1.1. Underwriters of the ten energy technology IPOs in our sample were identified and their respective Ritter adjusted Carter-Manaster reputation ranking secured. In total, 18 different underwriters were listed on the first page of the IPO prospectus for our ten sample companies. The results for a representative sample of those underwriters follow in Table Beatty and Ritter (1986). 23 Carter and Manaster (1990). 24 Carter and Manaster (1990) and Carter, Dark and Singh (1998). 25 Allen and Faulhaber (1989). 26 Johnson and Miller (1988). 27 Jay Ritter is an IPO expert conducting research at the University of Florida. For underwriter rankings, see 12

13 Table 3. Underwriters, reputation and frequency of lead and co-manager Times Lead or Co-lead Underwriter C-M Rating Underwriter Times Non-Lead Underwriter Goldman, Sachs & Co Salomon Smith Barney Deutsche Banc Alex Brown Banc of America Securities LLC Bancamerica Robertson Stephens Montgomery Securities Stephens Inc Morgan Keegan & Company, Inc Needham & Company, Inc First Albany Corporation Merrill Lynch & Co Morgan Stanley Dean Witter Hambrect & Quist CIBC World Markets Bear, Stearns & Co. Inc First Security Van Kasper The Robinson-Humphrey Company FAC/Equities Sources: Company IPO prospectuses and Ritter website ( Notes: Lead underwriter appears more than ten times due to co-lead mandates. Underwriters with a wide-range of reputation ranks take energy technology companies public. The most frequently identified underwriters are the best in the business. Several IPOs were, however, underwritten by underwriters with much lower Ritter adjusted Carter-Manaster rank. Underpricing and short-term performance Underpricing occurs when the price at which the IPO share is first sold is less than the actual market price, the actual market price being established on the first day of public trading after sale of the IPO shares. According to some research, underpricing occurs with almost all issues 28 and the amount of underpricing may vary by country. 29 Additionally, others have found that underpricing occurs only during specific periods, 30 that it occurs most often in specific industries, 31 and that the level of underpricing has changed over time. 32 A wide range of theoretical explanations for this phenomenon have been offered: price as a signal of favorable prospects for the firm, 33 underpricing as a discount for uncertainty and hidden information, less underpricing from the most reputable venture capitalists, underpricing as a form of underwriter insurance against claims of inaccurate pricing, the need for the underwriter to ensure that the issue can be resold, and corruption. 34 Overpricing is rare, but it does occur. When a 28 Ibbotson (1975). 29 Goergen et al. (2003). 30 Ibbotson and Jaffe (1975). 31 Ritter (1984). 32 Loughran and Ritter (2004). 33 Allen and Faulhaber (1989) and Grinblatt and Hwang (1989). 34 Loughran and Ritter (2004), Beatty and Ritter (1986), Ritter and Welch (2002), and Rock (1986). 13

14 company s IPO share price increases on the first day of trading, and is thus underpriced, the company is said to have left money on the table. 35 The extent to which an issue is underpriced will also determine the rate of return in the shortterm. In the literature, short-term performance is defined a couple of ways. For example, a oneday (the first day the IPO share trades) rate of return can be calculated as the difference between the offering price and the first day closing price. Alternatively, any period of time less than one year can be used. Short-term performance has been studied in depth by Ritter and it is linked to underpricing. Ritter (2002) found that for the 6,249 US IPOs that took place between 1980 and 2001, the average first-day rate of return was 18.8 percent. Gains, however, tend to be on paper only, because many of the investors at the IPO price either explicitly or implicitly agree not to flip the shares. 36 For each company in the sample group, an analysis of underpricing was conducted by calculating the first-day rate of return and the amount of money left on the table. The results of that analysis are shown below in Table 4. Table 4. Underpricing and short-term performance Company IPO Date First Day Return ($/Share) First Day Return Shares Issued Amount To Issuer ($ million) Money Left on the Table ($ million) Active Power, Inc. 8/8/ ,000, Advanced Power Tech. 8/8/ ,455, AstroPower Inc. 2/13/ ,700, Beacon Power 11/17/ ,000, Caminus Corporation 1/28/ ,572, Capstone Turbine Corp. 6/29/ ,090, Evergreen Solar 11/2/ ,000, Millennium Cell, Inc. 8/9/ ,000, Plug Power Inc. 10/29/ ,000, Power-One, Inc. 10/1/ ,000, Total Sources: Company IPO prospectuses, and own analysis. Notes: Amounts in millions rounded. Shares issued include only those sold by the company. First trading day rates of return varied widely. Investors in Millennium s IPO received no first day increase. Alternatively, investors in Active Power and Capstone Turbine would have experienced first day rates of return of 210 and 200 percent respectively. Consistent with our observations concerning rates of return, the amount of money left on the table also varied for our study group. In one case, Millennium Cell, no money was left on the table. In practice, the company and underwriters either valued the company the same way the market did or decided not to underprice. In two other cases, significant amounts of money were left on the table. Active Power s IPO left approximately $286 million and Capstone Turbine left $291 million on the table, both of which significantly exceed the amount they received. 35 Ritter (2003). 36 Aggarwal (2003). 14

15 Long-term performance IPOs also exhibit certain rate of return characteristics over longer time periods. Aggarwal (2003) argued that IPOs are overpriced in the long-term and investors in IPOs systematically lose money. Aggarwal also found that IPOs of young companies that go public in heavy trading volume years do worse than average, firms tend to go public at the peak of industry-specific fads, and issuers that successfully time markets get lower costs of capital. Contrary to similar findings by Ritter, 37 research by Brav and Gompers (1997) found that IPOs of small issuers might be particularly susceptible to long-term underperformance, but that it may be the smallness of the firm, not the IPO that explains the underperformance. Two long-term rates of return were calculated for our ten energy technology IPOs: after one year and as of July 30, A summary of that analysis is shown below in Table 5. Table 5. Long-term performance Company IPO Price ($/Share) One Year Closing Price ($/Share) Return One Year 7/30/04 Closing Price ($/Share) Return Through 7/30/04 NasdaqNM Index Active Power, Inc Advanced Power Tech AstroPower Inc Delisted Delisted Delisted Beacon Power Caminus Corporation Acquired Acquired Acquired Capstone Turbine Corp Evergreen Solar Millennium Cell, Inc Plug Power Inc Power-One, Inc Sources: Company IPO prospectuses, and own analysis. Notes: NasdaqNM Index is the percentage change in the index between the date of the respective IPO and July 30, First year rates of return were positive and negative. Evergreen Solar and Beacon Power shares lost over 80 percent of their value during the first year of trading. AstroPower, Plug Power, and Caminus all appreciated significantly. After the first year, the picture clears. Except for Caminus, which was acquired by Itron, all of the energy technology IPO shares had lost significant value relative to the IPO price. AstroPower filed bankruptcy. All IPO shares, except Advanced Power Technologies, performed worse than the NasdaqNM index between the IPO date and July 30, Risk The literature contains relatively little on the nature of post-ipo risk. For purposes of the analysis in this paper, and as an indicator of post-ipo risk, equity betas are shown for the sample group. 37 See for example Ritter (1991). 15

16 An equity beta is a measure of the extent to which the price of a share changes over time relative to a defined market benchmark. For example, if the price of a share changes in exactly the same proportion as the value of the benchmark, the share has a beta value of 1.0. A share with more pronounced changes relative to the market would have a beta of more than 1.0 and a share that changes in price less dramatically than the market will have a beta of less than 1.0. Beta is a key, albeit controversial, variable linking risk and rates of return. Equity betas were secured for the eight energy technology companies in our sample that still trade. The equity betas provided by Yahoo are calculated as the monthly stock price change relative to the monthly price change of the S&P500 Index, a commonly used market benchmark. Yahoo uses monthly data and a time period of 5 years when data is available, but not less than 2.5 years when limited data is available. The equity betas are shown below in Table 6. Table 6. Risk Company Historical Equity Beta Active Power, Inc Advanced Power Technologies 2.64 Beacon Power 2.72 Capstone Turbine Corp Evergreen Solar 2.29 Millennium Cell, Inc Plug Power Inc Power-One, Inc Source: Notes: Yahoo shows Beta s in the Key Statistics section under each company for which data is available. The eight energy technology companies in our sample for which betas are shown are risky investments, relative to the market as a whole. Millennium is marginally more risky than the market as a whole, with a beta of The other seven companies are significantly more risky. Underwriter expenses Underwriters receive compensation in various forms for taking companies public. For example, they may receive a fixed fee and/or a gross spread on the shares they distribute. The gross spread is the difference between the price at which the underwriter purchases the issue and the price at which the issue is resold. Receiving post-ipo trade flow from entities to which it has allocated IPO shares may also compensate underwriters. Chen and Ritter (2000) revealed a strong tendency for all underwriters to regularly set gross spreads at 7 percent. In affect, underwriters do not compete with each other on price. For each company in the sample group, the underwriting expenses were identified from the IPO prospectus. The results of that analysis are shown in Table 7. 16

17 Table 7. Underwriter expenses Expenses as % of Offering Value Frequency Range ($ millions) < 7% 0 - = 7% to > 7% 0 - Mean 7% 4.70 Sources: Company IPO prospectuses and own analysis. Underwriting fees for the ten IPOs came in at 7 percent of issue value. Energy technology IPOs are identical to other IPOs in that respect. Venture capital backing Most IPOs are not backed by venture capitalists. 38 Evidence suggests, however, that companies backed by venture capitalists are more successful and that their IPOs will perform better than a non-venture capital backed IPO. 39 The rationale for these findings is that venture capitalists have access to the top tier investment bankers, have better information about their portfolio companies, stay with their investments long after the IPO, and have their reputations at stake. For each company in the sample group, 5 percent owners were identified and any that looked like venture capital companies or nominees were flagged. If a company had venture capital backing it was tagged with a yes and if it did not receive venture capital backing it was tagged with a no. For purposes of evaluating the role and importance of venture capital backers with respect to IPOs in this industry, a comparison of rates of return are shown in Table 8. Table 8. Venture capital backed IPOs Company Venture Capital Backed First Day Return Return One Year Return Through 7/30/04 NasdaqNM Index First Day thru 7/30/04 Advanced Power Tech. No Millennium Cell, Inc. No Power-One, Inc. No Active Power, Inc. Yes AstroPower Inc. Yes Delisted Delisted Beacon Power Yes Caminus Corporation Yes Acquired Acquired Capstone Turbine Corp. Yes Evergreen Solar Yes Plug Power Inc. Yes Sources: Company IPO prospectuses, and own analysis. 38 Timmons and Spinelli (2004). They show that in 5 of the 6 years between 1996 and 2001, less than 50 percent of all IPOs were venture capital backed. 39 Barry et al. (1990) and Megginson and Weiss (1991). 17

18 One-year returns look as if venture capital backed energy technology companies in our small sample outperform non-venture capital backed companies, but it is too early to generalize given the limited size of the sample. We will be investigating this point in detail in the full study. Longer-term performance looks as if venture capital backed companies might slightly under perform for the sample group. Confirmation of this observation and an explanation for why it may occur will also be included in later papers. Discussion and Conclusions The sudden surge in energy technology IPOs between 1990 and 2003 was precipitated and facilitated by an uncanny confluence of market, regulatory, technological, and social trends. Power markets opened to new players, facilitating entry by new technologies and increasing demand for new products and services, including energy management, power quality and storage. Stock market growth accelerated at the tail end of a long 20-year boom, supported in part by global spreading of an equity culture and increasing demand for socially responsible investments. Widespread adoption of personal computer technology and introduction and subsequent growth of Internet technologies helped increase demand for absolute amounts and higher quality electricity production while at the same time providing technological infrastructure that could be used to solve the problems it created. And finally, heightened awareness of the quality of the environment and the need for alternative sources of electricity increased interest in new forms of generation, including wind, solar, and biomass. Each of these factors contributed in some way to the emergence of a market for energy technology IPOs. With respect to the results of this exploratory study, we make a couple of important observations. First, investors provided almost $624 million in financing to these energy technology companies when they purchased IPO shares. This is a significant amount of capital and it is evidence that financial markets and sustainable energy technologies are connected. On the other hand, $643 million in capital was left on the table. Ideally, that capital would have gone to the issuer and used to promote sustainable energy technologies. Leaving money on the table, however, is common practice in the IPO market, and one that may be needed to entice buyers. Second, energy technology IPOs experienced significant first day runups in price but fell in value in the long-term. Finally, energy technology IPOs seem to exhibit characteristics that are similar to other IPOs in many respects. The analysis in this paper highlights several implications for our larger study. First, given that the performance of energy technology IPOs varies so strongly, a comparison with IPOs in other sectors (such as information technology or biotechnology) is a necessary prerequisite to understand whether the sector as a whole appears to be financially attractive to investors, in other words whether energy technology has been a "good" or "bad" investment relative to alternatives. Second, we have observed that a number of very reputable investment banks have been involved in taking energy technology companies public. This, however, seems to have changed recently. This up-and-down cycle is mirrored by the level of in-house expertise that these banks had once built up in the energy technology sector, which is now gone. Whether or not a lack of such competence will be a hindering factor for the future of energy technology IPOs will be interesting to investigate. Third, since we have identified a substantial amount of underpricing for the 10 IPOs that we analyzed in this paper, the question arises whether energy technology 18

19 companies have experienced higher levels of underpricing than comparable IPOs in other sectors, and if they have, what this tells us about either the skills of the underwriters or the risk premium (or lack-of-credibility discount) implied by investors in this newly emerging industry segment. Fourth, extending our study from the current US sample to Canada, Australia, and Western Europe will provide us with insights about country-specific characteristics of the energy technology IPO process and the companies, underwriters and investors involved in it. Fifth, it will be important to assess the extent to which historical experiences of investors in energy technology IPOs help or hinder incremental commitments of capital via venture capital, IPOs, and other investment forms. Sixth, given that the events and trends that created a favorable context for the surge in energy technology IPOs in the late 1990s may not repeat, at least not in the short term, we should gauge whether the context for energy technology IPOs will ever be right again. And finally, we will want to know if there any clear winners and losers in this process? References Aggarwal R Allocation of initial public offerings and flipping activity. Journal of Financial Economics 68: pp Allen F and Faulhaber GR Signaling by underpricing in the IPO market. Journal of Financial Economics 23: pp Bagley CE and Dauchy CE The Entrepreneur s Guide to Business Law, 2 nd Ed. West Legal Studies in Business, Mason, Ohio. Balvers RJ, McDonald B, Miller RE Underpricing of new issues and the choice of auditor as a signal of investment banker reputation. The Accounting Review 43(4): pp Barry CB, Muscarella CJ, Peavy JW, and Vetsuypens MR The role of venture capital in the creation of public companies: Evidence from the going-public process. Journal of Financial Economics 27: pp Beatty RP and Ritter J Investment banking, reputation, and the underpricing of initial public offerings. Journal of Financial Economics 15: pp Beatty RP Auditor reputation and the pricing of initial public offerings. The Accounting Review 64(4): pp Brav A and Gompers PA Myth or reality? The long-run underperformance of initial public offerings: Evidence from venture and nonventure capital-backed companies. The Journal of Finance 52(5): pp Bygrave WD and Timmons JA Venture Capital at the Crossroads, Harvard Business School Press, Boston, Massachusetts. Carter R and Manaster S Initial public offerings and underwriter reputation. The Journal of Finance 45(4): pp Carter RB, Dark FH and Singh AK Underwriter reputation, initial returns, and the longterm performance of IPO stocks. The Journal of Finance 53(1): pp Chen H and Ritter JR The seven percent solution. The Journal of Finance 55(3): pp Daily CM, Certo ST, Dalton DR, and Roengpitya R. Spring IPO underpricing: A metaanalysis and research synthesis. Entrepreneurship Theory and Practice: pp