Capital Gains Tax Rates and The Cost of Capital For Small Business Evidence From The IPO Market

Journal of Financial Economics 53 (1999) 385}408
Capital gains tax rates and the cost of capital

for small business: evidence from the IPO
market夽
David A. Guenther , Michael Willenborg *
College of Business and Administration, University of Colorado, Boulder, CO 80309, USA
School of Business, University of Connecticut, Storrs, CT 06269, USA
Received 7 July 1998; received in revised form 12 October 1998
Abstract
We examine the issue prices of small initial public o!erings around the 1993 tax law
change that reduced the capital gains tax on quali"ed small business stock. We compare
the actual issue price of new stock with a benchmark price that is not a!ected by the
change in capital gains tax. We "nd that, after controlling for IPO underpricing, the issue
prices of qualifying small business stock after the tax rate change are signi"cantly higher
than the issue prices before the change. A control sample of nonqualifying "rms shows no
signi"cant di!erence in issue prices. 1999 Elsevier Science S.A. All rights reserved.
JEL classixcation: G32; H25
Keywords: Small business; Initial public o!erings; Capital gains tax
* Corresponding author. Tel.: #1-860-486-3020; fax: #1-860-486-4838.

E-mail address: michael.willenborg@uconn.edu (M. Willenborg)
夽
We thank the anonymous referee. We also thank participants at the 1998 University of North
Carolina Tax Conference, particularly our discussant Jay Ritter. Helpful comments on an earlier
version were received from Mark Correll, Leslie Eldenburg, Betty Jackson, Ray King, Ken Klassen,
Alan Macnaughton, Lil Mills, Frank Selto, Toby Stock, and workshop participants at the Univer-
sity of Arizona, the University of Colorado at Boulder, the University of Oregon, and the University
of Waterloo. Financial support for this study from the Ernst & Young Foundation is gratefully
acknowledged.
0304-405X/99/$ - see front matter 1999 Elsevier Science S.A. All rights reserved.
PII: S 0 3 0 4 - 4 0 5 X ( 9 9 ) 0 0 0 2 6 - 4
386 D.A. Guenther, M. Willenborg / Journal of Financial Economics 53 (1999) 385}408
1. Introduction
An important public policy question is whether the capital gains tax rate
a!ects common stock pre-tax returns and thus the corporate cost of capital. In
1993 Congress attempted to lower the cost of capital for small businesses in the
U.S. by enacting a provision that eliminates the tax on one-half of the gain
realized from selling &quali"ed small business stock' provided the stock is held
for at least "ve years. This tax bene"t, contained in Section 1202 of the Internal
Revenue Code, is available only to individual shareholders who purchase the
stock directly from the issuing corporation and applies only to stock of issuing
corporations with total assets of less than $50 million (after issuance).
The capital gains tax reduction a!ects the tax paid by investors on future
gains from selling quali"ed small business stock. With perfect and complete
markets, expected after-tax returns on investments should remain unchanged,
and the expected future tax reduction should be passed on to the issuing
corporation in the form of a higher stock price (and hence a lower cost of
capital), consistent with the intent of Congress in enacting the 1993 legislation.
This increase in price (and decrease in before-tax return) of tax-favored assets is
referred to by Scholes and Wolfson (1992) as an &implicit tax'.
In this study we examine the issue prices of small initial public o!erings
(IPOs) both before and after the e!ective date of the tax rate change (August 10,
1993). We identify a sample of 177 IPOs in 1993 and 1994 that meet all of the
requirements contained in the Internal Revenue Code for issuing quali"ed small
business stock. We also select a control sample of 51 larger IPOs during the
same time period that are too big to qualify under the rules of Section 1202. We
measure the tax e!ect on the issue price by comparing the actual issue price of
the new stock with a benchmark price (the &tax-neutral price') that is not a!ected
by the change in the capital gains tax. The tax-neutral price is the closing market
price of the stock on the "rst trading day. This tax-neutral price is not a!ected
by the capital gains tax change because only shares of stock acquired directly
from the issuing corporation are treated as quali"ed small business stock.
Therefore, anyone purchasing the stock in the market on the "rst trading day
would not be purchasing quali"ed small business stock and would not be
eligible for the lower capital gains tax on a future sale. Because our measure of
the tax e!ect also contains a component that is commonly referred to as
&underpricing' in IPOs, we also include control variables that have been shown
in prior studies in accounting and "nance to explain underpricing.
Certain features of our sample "rms make it di$cult to predict ex ante the
magnitude of the change in price in response to the tax rate reduction. Firms
that meet the tax requirements for issuing quali"ed small business stock are
much smaller than those typically studied in prior research, and the small size
makes it likely that investors in these "rms are individuals (rather than institu-
tions) who may be unsophisticated with respect to investment decisions (Brav
D.A. Guenther, M. Willenborg / Journal of Financial Economics 53 (1999) 385}408 387
and Gompers, 1997). In addition, the characteristics of these "rms and their
investment bankers are di!erent from those in most previous studies of IPOs.
For example, the majority of our sample "rms issue &units' (i.e., bundles of stock
and warrants) rather than stock, and over 80% of our sample "rms have
investment bankers ranked &low quality' using the Carter and Manaster (1990)
rankings. Our sample "rms are also likely to be in the category of small
nonventure-backed "rms that Brav and Gompers (1997) "nd account for the
IPO underperformance documented by Ritter (1991) and Loughran and Ritter
(1995). Some researchers have even suggested that individual investors in small
IPOs act irrationally (see, e.g., Loughran and Ritter, 1995; Brav and Gompers,
1997; Shiller, 1990). All of these factors may work to reduce the e$ciency of the
market for the stock of small IPOs. The magnitude of the change in price of
quali"ed small business stock in response to the tax rate reduction is ultimately
an empirical question.
Our results demonstrate that, after controlling for IPO underpricing, the issue
prices of quali"ed small business stock issued after August 10, 1993 are signi"-
cantly higher (compared with the "rst-day trading price) than the issue prices of
shares issued prior to that date. These results appear robust to a number of
possible alternative explanations such as overall IPO market trends, outliers,
changes in interest rates, and changes in the number of small IPOs going to
market. We interpret our results as providing evidence that the 1993 tax change
is associated with a signi"cant increase in the prices received for small IPOs,
a result consistent with the stated intent of Congress when the legislation was
introduced. Interestingly, although Congress appears to believe that lowering
the cost of capital for U.S. small businesses is an important public policy goal,
this view is not necessarily consistent with empirical evidence (see, e.g., Ritter,
1991; Holtz-Eakin, 1995).
Our results imply that nearly all of the future tax bene"ts from the rate
reduction were passed on to the issuing corporations in the form of higher stock
prices rather than retained by investors. This "nding can be compared with
other implicit tax studies of tax sharing, such as Shackelford (1991), Guenther
(1994), Engel et al. (1998), and Erickson and Maydew (1998). While Shackelford
"nds that most of the tax bene"ts are passed on to borrowers (implying a large
implicit tax), Engel et al. "nd surprisingly small estimates of implicit tax e!ects in
debt-equity hybrid securities. Guenther "nds the change in yields of Treasury
bills in response to tax rate changes to be much smaller than that implied by the
size of the rate change, and Erickson and Maydew "nd small implicit tax e!ects
for preferred stock. However, the relatively high degree of risk associated with
our very small IPOs and the possibility of seemingly irrational investor behavior
in the small IPO market make it a much di!erent setting from those studied by
previous researchers.
The results of this study enhance our understanding of IPO pricing, parti-
cularly the pricing of the very small IPOs that are rarely studied by researchers,
Schultz (1993) being an exception. In addition, our results provide evidence that
capital gains tax rates a!ect the prices of equity securities, a topic studied in
a more general context by Collins and Kemsley (1998) and Lang and Shackel-
ford (1998). Finally, our results make an important contribution to public policy
research in taxation by providing evidence that a tax law change targeted at
achieving a speci"c public policy objective } in this case reducing the cost of
capital for small businesses } can achieve its stated purpose. This issue is still an
important one to Congress, as evidenced by the fact that the recent Taxpayer
Relief Act of 1997 contains a provision that allows taxpayers to &roll over'
tax-free a gain from the sale of quali"ed small business stock when the proceeds
are used to purchase other quali"ed small business stock within 60 days of the
sale. Although the results of this study are only applicable to relatively small
"rms, Petersen and Rajan (1994, p. 5) point out that small "rms are an important
component of the national economy, and that &an important measure of the
e$ciency of a "nancial system is the extent to which such "rms are nurtured and
have access to the capital necessary for growth'. This study provides evidence
that helps us to better understand that process.
The balance of the paper is organized as follows. Section 2 discusses the
tax rules relating to gains on the sale of quali"ed small business stock, and
Section 3 discusses our research design and control variables relating to IPO
underpricing issues. Section 4 discusses the sample selection process and
measurement of variables, and Section 5 presents results of our empirical
tests. Section 6 concludes. Appendix A provides an excerpt from the IPO
prospectus of a quali"ed small business issuer, and Appendix B provides an
example of the e!ect of the Section 1202 capital gains tax rate change on IPO
underpricing.
2. Taxation of gains of qualifying small business stock
Section 1202 of the Internal Revenue Code, added by the Revenue Reconcili-
ation Act of 1993, excludes from taxable income of noncorporate taxpayers 50%
of the gain from the sale of quali"ed small business stock held for more than "ve
years. In this section of the paper we brie#y discuss the history of this tax
provision and provide an overview of the rules that have to be met to achieve
favorable tax treatment. An understanding of these tax rules is important, since
many of the restrictions imposed during our sample selection process are
designed to ensure that our sample "rms actually qualify for this special tax
treatment.
Tax legislation to exclude a portion of the gain from selling small business
stock was originally introduced by Senator Dale Bumpers in 1987, and was
reintroduced in 1989, 1990, and 1991. In 1992 Congress "nally adopted the
legislation, but the provision was vetoed by President Bush. The legislation was
introduced again in early 1993, and eventually became part of the 1993 Revenue
Reconciliation Act. In his remarks to the Senate upon reintroduction of the bill,
Senator Bumpers stated that the legislation was &a capital investment
tax incentive that challenges Americans to make high-risk long-term growth-
oriented investments in the enterprises that will lead America into the 21st
Century' (Congressional Record, February 16, 1993). The legislation had
the support of the new Clinton administration. The Chairman of the Council
of Economic Advisors, Laura D'Andrea Tyson, explained the legislation
as &an attempt to use capital gains relief in a very targeted way for long-term
investments by the small business community, and we feel that it's a very
important part of our proposals' (Tyson, 1993, p. 1). This proposed tax legisla-
tion was also seen as important by the investment community: &Most Street
"rms do not issue stock for companies this small, but PaineWebber Inc. and
others are exploring vehicles for investors to pump money into portfolios of
small companies, from limited partnerships to hedge funds' (Business Week,
March 8, 1993, p. 78).
To qualify for the 50% gain exclusion, the stock sold must be quali"ed small
business stock. Quali"ed small business stock means stock of a domestic
corporation originally issued after August 10, 1993 (i.e., the date of enactment)
provided the following: (1) the issuing corporation has gross assets of $50 million
or less (after issuance), (2) the stock is acquired at its original issuance (either
directly or through an underwriter), and (3) the corporation meets an &active
business' requirement during substantially all of the "ve-year holding period of
the stock. Only stock in a &C corporation' is quali"ed small business stock.
A C corporation is any corporation that has not made an election to be taxed
under partnership-type rules as an &S corporation'. In general, publicly held
corporations are ineligible to make such an election, and therefore all of our
sample "rms will be C corporations.
The active business requirement is satis"ed if the corporation uses at least
80% of the value of its assets in the active conduct of one or more quali"ed
trades or businesses. A quali"ed trade or business is any trade or business other
than the following:
1. any trade or business involving the performance of services in the "elds of

health, law, engineering, architecture, accounting, actuarial science, perform-
ing arts, consulting, athletics, "nancial services, brokerage services, or any
trade or business where the principal asset of such business is the reputation
or skill of one or more of its employees;
2. any banking, insurance, "nancing, leasing, investing, or similar business;
3. any farming business;
4. any business involving the production or extraction of minerals subject to
percentage depletion (e.g., oil and gas, coal);
5. any business of operating a hotel, motel, restaurant, or similar business.
The following types of corporations do not meet the active business require-
ment: a DISC or former DISC, a possessions corporation, a regulated invest-
ment company, a REIT, or a cooperative.
In addition to the above rules, a corporation will not meet the active business
requirement if more than 10% of the value of its net assets consists of stock or
securities in other corporations. For purposes of this rule, stock of 50% (or
more) owned subsidiaries is not counted. Finally, a corporation will not meet
the active business requirement if more than 10% of the value of its assets
consists of real property that is not used in the active conduct of a quali"ed trade
or business. (The ownership of, dealing in, or renting of real property is not
treated as the active conduct of a qualifying trade or business.)
3. Research design + controlling for IPO underpricing
Since we investigate di!erences in initial o!ering prices before and after the
1993 reduction in the capital gains tax, it is important in our research design to
control for factors other than taxes that a!ect the pricing of IPOs. Empirical
studies have consistently identi"ed the puzzling regularity that, on average, new
issues experience dramatic increases in price on the day of going public, a phe-
nomenon characterized as &underpricing'. The degree of underpricing (also
referred to as the &initial return') is often calculated as the percentage di!erence
between the o!ering price and the "rst closing market price. Research in "nance
has advanced several di!erent theories in an attempt to explain this phenom-
enon of positive average initial returns, ranging from rents or signals (resulting
from information asymmetry) to implicit insurance premiums. However, no
single theory of initial returns has been found to be consistent with all of the
existing empirical evidence (Ibbotson et al., 1994).
Much of the "nance literature portrays the initial return phenomenon as
evidence that IPOs are deliberately priced at a discount relative to their "rst
aftermarket price. In an attempt to provide an explanation for this seeming
contradiction to e$cient capital markets, many theories of underpricing assert
informational asymmetries among the parties involved in the transaction. Rock
(1986) applies the concept of the winner's curse to the IPO market assuming an
asymmetry about the true value of a "rm's shares between informed and
uninformed investors. He argues that underpricing arises both to compensate
certain investors for becoming informed about share value and to limit unin-
formed investors' exposure to an adverse selection problem and prevent them
from withdrawing from the marketplace. Beatty and Ritter (1986) extend Rock's
model and argue that underpricing should be positively associated with the level
of ex ante uncertainty that uninformed investors have about the true value of an
IPO "rm's shares. Welch (1989) proposes a signaling model in which high-
quality "rms deliberately underprice at the IPO to convey a costly signal which
is not easily imitated by low-quality "rms, thereby cultivating investor favor and
obtaining higher prices for subsequent equity o!erings. Tinic (1988) claims that
underpricing is a premium for an implicit insurance policy against legal liability
for potential security law violations of issuers and their agents, most notably
investment banks. Ritter (1984a) suggests that underpricing results from the
monopsony power of investment banks that specialize in the underwriting of
small, speculative "rms. Shiller (1990) argues that underpricing occurs as a result
of investment bankers attempting to cultivate a shortage illusion, a theory he
terms the impresario hypothesis.
If Section 1202 achieves its intended purpose, IPO o!er prices should increase
for companies issuing quali"ed small business stock to individuals. In this paper,
we examine whether issue prices of quali"ed small business stock increase in
response to the 1993 tax rate change by comparing the initial IPO price with the
closing (i.e., tax neutral) price as of the end of the "rst trading day. Because this
measure of the tax e!ect also contains a measure of the initial returns phenom-
enon, we control for underpricing with the following proxies for ex ante
uncertainty from the accounting and "nance literature: the presence of a unit
o!ering (Schultz, 1993), company age (Beatty, 1989; Ibbotson et al., 1988;
Schultz, 1993), underwriter reputation (Beatty and Ritter, 1986; Tinic, 1988;
Carter and Manaster, 1990; Schultz, 1993), size (Ibbotson et al., 1988; Tinic,
1988; Schultz, 1993), the percentage of ownership retained (Leland and Pyle,
1977), the IPO o!er price per share (Ibbotson et al., 1988; Tinic, 1988;
Maksimovic and Unal, 1993), and auditor reputation (Balvers et al., 1988;
Beatty, 1989; Michaely and Shaw, 1995).
Given the small business and &small deal' focus of our primary sample
selection (see Section 4 for details), Schultz's (1993) study on unit IPOs is
particularly relevant. Companies can choose to go public by selling common
shares only or by selling common shares bundled with other securities (i.e., by
selling units), primarily stock purchase warrants. Schultz "nds that "rms going
public via unit IPOs are smaller and younger than "rms issuing share IPOs and
that these unit IPOs experience signi"cantly higher levels of underpricing.
Because we wish to ensure that the shares meet the requirements of Section
1202, our sample selection of quali"ed small business stock focuses on IPOs that
raise a relatively small amount of proceeds. Schultz provides evidence that the
presence of unit IPOs is more likely with smaller o!erings and, as such, whether
a small-deal IPO is issued in units is likely an important covariate for our study.
As a result, the "rst four of our underpricing variables (i.e., unit IPO, company
age, underwriter reputation, and size) are included because they constitute
Schultz's best-"tting, most parsimonious model of initial returns.
Our remaining variables (i.e., ownership retained, the o!er price per share,
and auditor reputation) are important because of research design issues. Owner-
ship retained is connected to both signaling (Downes and Heinkel, 1982) and
agency (Ritter, 1984b) explanations and, as reported by Beatty and Welch
(1996), the sign on this parameter changes depending on whether the sample
consists of young/small company IPOs or older/larger company IPOs. Our
primary sample is similar to Beatty and Welch's young/small company sample,
wherein they "nd that the level of retained ownership is positively associated
with IPO underpricing. Because we are interested in testing the impact of
Section 1202 on IPO share prices, we need to control for any other potential
share-price related e!ects on underpricing. Our sample potentially contains
smaller, speculative, &penny-stock' issues which, as Ibbotson et al. (1988) discuss,
often have o!er prices of less than $3 and experience extremely high levels of
underpricing. Finally, we control for the reputation of the issuing "rm's auditor
because the accounting literature provides evidence both that IPO underpricing
is inversely related to auditor size and that the presence of a larger auditor is
positively related to "rm size (e.g., Simunic and Stein, 1987).
4. Sample selection and variable measurement
4.1. Sample selection
The empirical analysis focuses on IPOs that likely qualify for Section 1202
status, in the sense that these issues represent the sale of quali"ed small business
stock to individual (i.e., noncorporate) investors. However, to ensure that our
"ndings regarding these smaller, tax-favored IPOs are robust to the possibility
of general temporal shifts in the IPO market, we also use a control sample of
larger issues that are not quali"ed small business stock. For the quali"ed small
business issuer sample, we focus on small-deal IPOs to provide assurance that
the securities are likely purchased by individual investors eligible for the favor-
able capital gains treatment under Section 1202. Within this population of
small-deal IPOs, we further identify that subset of new issues by small businesses
whose shares likely represent quali"ed small business stock.
Table 1 provides details on the sample selection for both the small IPOs of
quali"ed small business stock and the control group of larger IPOs. In Panel
A we identify a population of 270 small, "rm-commitment, Nasdaq-traded IPOs
by domestic, commercial companies during 1993 and 1994 using the Investment
Dealer's Digest weekly newsletter Going Public: The IPO Reporter (Going
Public). Because the focus on identifying IPOs likely to qualify for the favorable
tax treatment under Section 1202 leads to a prevalence of unit o!erings in our
small-deal, small-company sample, we consider our sample identi"cation/data
collection e!orts preferable to alternative approaches such as the Securities
Data Corporation database; Beatty and Welch (1996) discuss certain de"-
ciencies of the SDC database as it relates to unit IPOs. Our delineation of the
small-deal segment of the IPO market is by reference to the Securities and
Exchange Commission's (SEC) cuto! for "ling a Form SB-1, appropriate for
Table 1
Sample selection of small, "rm-commitment Nasdaq IPOs by quali"ed small business issuers and
a control group of larger, "rm-commitment Nasdaq IPOs. For both samples we initially select IPOs
by domestic, commercial issuers and then eliminate issuers operating in trades or businesses not
covered in Section 1202. For the sample of small IPOs we select issues raising $10 million or less (the
gross proceeds cuto! for "ling SEC Form SB-1), and eliminate those issuers which, though raising
$10 million or less, choose to "le SEC Form S-1. For the sample of larger IPOs we select issues
raising $60 million or more to ensure that (even after deducting issue costs) the post-IPO assets likely
exceed the $50 million threshold contained in Section 1202.
Panel A: Small IPOs by qualixed small business issuers
Firm-commitment, Nasdaq initial public o!erings raising $10 million 270

or less during 1993 and 1994 by domestic, commercial issuers
Less: Issuers "ling SEC Form S-1 68
IPOs by small business issuers (i.e., Forms SB-1 and SB-2 "lers) 202
Less: Issuers in trades or businesses not covered in Section 1202
Services } athletics 2
Services } health 8
Services } law 2
Natural resources 1
Hotels, motels, restaurants and casinos 12 25
Small IPOs by quali"ed small business issuers 177
Panel B: Control group of larger IPOs
Firm-commitment, Nasdaq initial public o!erings raising $60 million 59

or more during 1993 and 1994 by domestic, commercial issuers
Less: Issuers in trades or businesses not covered in Section 1202
Natural resources 3
Hotels, motels, restaurants and casinos 5 8
Larger IPOs by issuers not qualifying for Section 1202 51
certain small business issuers. Our focus at this initial stage on domestic,
commercial companies is due to the requirements of Section 1202 and, as such,
we eliminate foreign-based companies and commercial banks, thrifts, real estate
entities, blind pools, and closed-end mutual funds. We then further screen these
270 IPOs and eliminate 68 issues by companies which, though raising an
amount of money within the SB-1 threshold, "le a Form S-1 with the SEC in
reference to their o!ering. The remaining 202 IPOs represent those issuers
The SEC instituted S-18 "lings in 1979 to provide small companies, de"ned as those seeking to
raise less than $7.5 million, with an alternative, less-burdensome registration requirement. S-18
"lings have since been replaced by SB-1 and SB-2 "lings, appropriate for small business issuers with
revenues of less than $25 million and, in the case of SB-1 "lers, which o!er up to $10 million worth of
securities in a "scal year.
which both "le an SEC registration form appropriate for small businesses (i.e.,
an SB-1 or SB-2) and raise an amount that falls within the guidelines for Form
SB-1 registrants. We further eliminate 25 IPOs because the issuer appears to be
in a trade or business that is excluded from the provisions of Section 1202 (e.g.,
health care services). These data screens result in a "nal sample of 177 IPOs by
quali"ed small business issuers, 137 of which were issued subsequent to the
e!ective date of Section 1202 (i.e., after August 10, 1993). Despite the expectation
of tax savings from the likely enactment of Section 1202 (which was adopted by
the House of Representatives on August 5 and the Senate on August 6), nine
sample "rms had IPO dates in July and two "rms had IPO dates between
August 1 and August 10; our results are not sensitive to the exclusion of these
"rms. It is impossible to tell how many "rms (if any) delayed their IPO dates.
In Panel B we also identify a population of 59 larger "rm-commitment,
Nasdaq-traded IPOs by domestic, commercial companies during 1993 and
1994. For the purposes of establishing a threshold to de"ne an o!ering not
qualifying for Section 1202 treatment, we identify those IPOs raising $60 million
or more. Our rationale for this cuto! is to ensure that, even after deducting stock
issue costs for deals of this size (typically an underwriter discount of 6% or 7%
plus out-of-pocket costs), the resulting post-IPO assets likely exceed the $50
million threshold contained in Section 1202. Following the industry screening
criteria above, we then eliminate eight IPOs because the issuer operates in
a trade or business that is excluded from the provisions of Section 1202. This
results in a "nal sample of 51 larger IPOs in our control group, 37 of which were
issued subsequent to the e!ective date of Section 1202.
4.2. Investors in small IPOs
To identify our primary sample of IPOs by quali"ed small business issuers, we

emphasize new issues that raise a relatively small amount of money to provide
assurance that these shares are likely being purchased by individual investors.
Brav and Gompers (1997, p. 1819) study the performance of small IPOs, and
assert that the equity of small IPOs &is held primarily by individuals'. Brav and
Gompers de"ne a small IPO as one with a market capitalization of $50 million
or less (p. 1792). In addition, under the provisions of Section 1202, mutual funds
(and other types of &pass-thru' entities like partnerships) could invest in quali"ed
small business stock, and individual investors in the mutual fund would be
entitled to the tax bene"ts of lower capital gains rates upon the future sale of the
stock by the mutual fund. However, for reasons discussed in the next paragraph,
we believe it is unlikely that mutual funds (or other institutional investors) invest
in IPOs of "rms as small as those in this sample.
Within the mutual fund industry, certain stock funds are designated as &small
cap' with stated investment objectives relating to investments in smaller, growth
stocks. The median market capitalization of stocks held by such funds during
the 1993}94 period was approximately $500 million (The Wall Street Journal,
October 8, 1997, pp. C1}C9). A more recent survey of the Morningstar mutual
fund database reveals 523 funds designated as focusing on stocks with small
market capitalizations (i.e., smallcap growth, smallcap value and smallcap
blend). The average median market capitalization for these 523 funds is $796
million, and only ten of these funds have a median market capitalization for
stocks in their portfolio of less than $100 million. Among the 177 observations in
our sample of small IPOs by quali"ed small business issuers, the company with
the largest initial market capitalization is PC Service Source, which went public
on March 29, 1994, selling 28.28% ownership for gross proceeds of $9,900,000
(a market capitalization of $35 million). Therefore, it seems likely that the IPOs
in our primary sample are not initially purchased by institutional investors.
Because of their size the larger IPOs in the control group do not represent
quali"ed small business stock; whether they are likely purchased by individual
investors is irrelevant to our research design.
4.3. Data sources and variable measurement
The primary sources for data collection are the original IPO prospectuses for
all 177 small-deal issues, and Going Public for the 51 larger IPOs in the control
group. From the prospectus, we identify whether the issuer is selling units (e.g.,
shares bundled with stock warrants) or shares only, the IPO o!er price per unit
or per share, the date of incorporation of the company or its oldest subsidiary,
the percentage of ownership retained by pre-IPO shareholders, the lead under-
writer, the audit "rm, and measures of company size. In the case of the control
sample of larger IPOs, from Going Public we identify, the IPO o!er price per
share, the percentage of ownership retained, the lead underwriter, and the audit
"rm. So as not to lose observations, we estimate the percentage of ownership
retained for seven IPOs for which this variable is missing from Going Public by
collecting the number of post-IPO shares outstanding from Compact Disclosure.
In addition, our primary sources for pre-IPO assets is Compact Disclosure
and for the date of incorporation we use Ward's Directory from 1998.
Interestingly, certain of these IPOs discuss their status as &quali"ed small
business stock' in their o!ering prospectus; Appendix A provides an example of
one such issue.
Because of the small-"rm nature of our primary sample, the majority of which
are issued as unit IPOs, many issuers do not appear on the CRSP tapes in the
period immediately following their o!ering, or only their common stock ap-
pears. As a result, the closing price at the end of the "rst day of trading is from
Standard and Poor's Daily Stock Price Record } OTC (S&P) (this source also
facilitates verifying whether an IPO was issued in shares or units). Underpricing
is de"ned as the one-day return from investing in the new issue and is computed
as the di!erence between the "rst-day closing price and the IPO o!er price as
a percentage of the IPO o!er price, minus the daily return of the OTC/Nasdaq
Industrial Market Indicator as collected from S&P.
We specify an indicator variable for the presence of a unit o!ering. Because
certain startup issuers are formed during the year of their IPO, whereas others
have been in existence for more than 50 years, we add one to a company's age
and again take a logarithmic transformation. Carter and Manaster (1990) group
117 underwriters associated with 501 "rm-commitment IPOs from January 1,
1979 to August 17, 1983 into 18 categories, ranging from 0.0 to 9.0, based upon
their position in &tombstone' announcements from Investment Dealer's Digest
and The Wall Street Journal. Carter et al. (1994,1998) update this proxy for IPOs
issued between January 1, 1985 and December 31, 1991 and provide rankings
for 169 underwriters, also ranging from 0.0 to 9.0. We use Carter et al.'s (1994)
updated rankings as a measure of underwriter prestige. To control for the e!ects
of size on underpricing, we specify a variable equal to the ratio of pre-IPO total
assets to total proceeds (Schultz, 1993). Following Tinic (1988) and Maksimovic
and Unal (1993), we control for the relation between o!er price and underpric-
ing using the inverse of the IPO price as a control variable. We control for the
e!ects of entrepreneurial ownership by including the percentage of voting shares
retained by pre-IPO shareholders and, in the case of unit IPOs, give no value to
warrants. Finally, to control for the e!ects of the auditor, we specify an indicator
variable for those IPOs audited by a Big 6 "rm (Balvers et al., 1988; Beatty,
1989).
5. Empirical results
5.1. Descriptive statistics
Table 2 presents descriptive statistics for the samples of 177 new issues by
quali"ed small businesses and the 51 new issues in the control group, partitioned
by whether the IPO is before or after the e!ective date of Section 1202.
Overall, and consistent with the "nance literature (e.g., Ibbotson et al., 1994),
the smaller new issues sustain a substantial degree of IPO underpricing, with
mean and median initial returns for the entire sample of 29.0% and 15.9%,
respectively. Underscoring the importance of o!er type among this sample, the
majority of these small-deal new issues by small companies are sold as bundles
of stock and warrants (i.e., units). Again, consistent with accounting and "nance
literature, these IPOs are underwritten by less-prestigious underwriters and are
less frequently audited by larger, more-prestigious Big 6 auditors. Important for
our study, these companies are quite small, with mean and median pre-IPO
total assets of $3.6 and $2.5 million, respectively. The largest issuer in our sample
is Sunbelt Companies, with pre-IPO total assets of $23.7 million. Sunbelt went
public on October 22, 1994, selling 625,000 shares at $7.75 and raising gross
Table 2
Descriptive statistics by pre- and post-Section 1202 dates. For the quali"ed small business issuers,
observations are the 177 Nasdaq-traded IPOs raising $10 million or less during 1993 and 1994 that
"le a small-business SEC registration form (i.e., SB-1 or SB-2) and operate in trades or businesses
quali"ed by Section 1202; 40 are pre-Section 1202 and 137 are post-Section 1202. For the control
group of larger IPOs, observations are the 51 Nasdaq-traded IPOs raising $60 million or more
during 1993 and 1994 that operate in trades or businesses otherwise quali"ed by Section 1202; 14 are
pre-Section 1202 and 37 are post-Section 1202.
Variable Quali"ed small business issuers Control group of larger IPOs
Total Pre-tax Post-tax Total Pre-tax Post-tax

change change change change
Underpricing Mean 0.290 0.375 0.265 0.102 0.140 0.087

Median 0.159 0.217 0.130 0.064 0.087 0.038
Unit Mean 0.582 0.475 0.613 0.000 0.000 0.000
Age Mean 9.220 11.250 8.628 22.824 14.929 25.811
Median 7.000 5.500 7.000 8.000 6.500 8.000
Underwriter Mean 1.584 1.654 1.563 8.215 7.904 8.333
Median 0.000 0.000 0.000 8.750 8.815 8.750
Assets Mean 3.557 2.992 3.722 382.133 117.213 482.372
Median 2.476 2.228 2.556 151.947 66.759 193.132
Minimum 0.084 0.084 0.144 7.338 18.526 7.338
Maximum 23.733 14.708 23.733 7571.300 363.299 7571.300
Proceeds Mean 5.873 5.578 5.960 100.529 85.243 106.313
Median 5.525 5.182 5.875 79.360 80.100 79.350
%Retained Mean 0.618 0.594 0.625 0.555 0.602 0.538
Median 0.615 0.600 0.643 0.605 0.625 0.590
Price Mean 5.746 5.489 5.821 16.289 15.946 16.419
Median 5.150 5.000 5.250 16.000 16.000 16.000
Big6Auditor Mean 0.537 0.625 0.511 1.000 1.000 1.000
CIPOs per month Mean 7.375 5.455 8.220 2.125 1.909 2.220
The variables are de"ned as follows:

Underpricing } (1st closing price!IPO price)/IPO price minus the daily return on the
OTC/Nasdaq Industrial Market Indicator from Standard & Poor's Daily Stock Price Record
Unit } one for a unit IPO (e.g., shares bundled with warrants) and zero otherwise
Age } the number of years from date founded or incorporated to IPO
Underwriter } a prestige ranking ranging from 0.0 to 9.0 (Carter et al., 1994)
Assets } pre-IPO total assets in millions
Proceeds } IPO gross proceeds in millions
%Retained } the percentage of voting common stock retained by pre-IPO shareholders and in the
case of unit IPOs, gives no value to warrants
Price } the IPO o!er price per share or per unit
Big6Auditor } one if the issuer is audited by a Big 6 "rm and zero otherwise
CIPOs per month } the average monthly number of IPOs issued during the respective tax regimes
proceeds of $4,843,750. After deducting an 8% underwriter discount, Sunbelt's

post-IPO total assets of approximately $28.2 million are considerably below the
threshold of $50 million set forth in Section 1202 as the upper limit for an issuer
to be considered as selling quali"ed small business stock.
As Table 2 shows, the level of underpricing decreases for the quali"ed small
business IPO sample during the post-Section 1202 period, despite an overall
increase in the number of issues per month. Whereas the pre-Section 1202
period from January 1, 1993 to August 10, 1993 contains 40 IPOs (approxim-
ately 5.5 per month), this increases to 137 IPOs during the post-Section 1202
portion of our sample (approximately 8.2 per month). This increase might be
consistent with the prediction that the tax breaks aimed at encouraging long-
term investments in small companies &2 could provoke a wave of initial public
o!erings by disreputable penny-stock "rms' (Business Week, March 8, 1993,
p. 78). This sort of supply side reaction to Section 1202 might re#ect a riskier
class of IPOs coming to market. There was an increase in the prevalence of unit
o!erings among small IPOs during the period after August 10, 1993, and
a decrease in the frequency of Big 6 auditors. In addition, the prospectuses of the
sample "rms show a signi"cant increase in the number of risk factors listed
during the period after the e!ective date of Section 1202 (see Feltham et al., 1991;
Beatty and Welch, 1996). However, an increase in riskiness of small IPOs
post-Section 1202 should increase underpricing, a result contrary to Table 2.
The right-hand columns of Table 2 provide descriptive statistics for our
control sample of 51 larger IPOs for which the favorable capital gains treatment
contained in Section 1202 does not apply. In contrast to the primary sample of
177 small IPOs, these larger deals sustain much less underpricing, are issued
entirely as share IPOs, are underwritten by high-prestige investment banks, are
much larger companies (in terms of pre-IPO assets, the smallest issuer in the
control sample is twice the size of the average issuer in the primary sample), and
are exclusively audited by Big 6 "rms.
The overall pattern of reduced underpricing after the e!ective date of Section
1202 is also mirrored in this larger IPO market segment. Therefore, the decline in
underpricing observed among the small deals might re#ect a temporal shift in the
IPO market rather than the enactment of Section 1202. However, in contrast to the
small IPO sample, several of the descriptive statistics are consistent with a decline in
underpricing. Among these larger IPOs, companies going public after August 10,
1993 are older and larger than those going public prior to this date, and both age
and size are known to vary inversely with initial returns. The multivariate test in
the next section will control for the e!ect of these variables on underpricing.
5.2. IPO underpricing pre and post Section 1202 } primary analysis
The empirical test for the e!ects of Section 1202 on the share prices of
quali"ed small business stock is based on the following ordinary least squares
regression:
;nderpricing"b #b ;nit#b ¸n(1#Age)#b ;nderwriter

#b Assets/Proceeds#b %Retained#b 1/Price

#b Big6Auditor#b Post¹ax#e (1)

where
Underpricing market-adjusted, one-day initial return
Unit one for a unit IPO and zero otherwise
¸n(1#Age) Ln(1#the number of years from date founded or incorpor-
ated to IPO)
Underwriter a prestige ranging from 0.0 to 9.0 (Carter et al., 1994)
Assets/Proceeds pre-IPO total assets/IPO proceeds
%Retained the percentage of voting common stock retained by pre-IPO
shareholders
1/Price the reciprocal of the IPO o!er price per share or per unit
Big6Auditor one if the issuer is audited by a Big 6 "rm and zero otherwise
PostTax one if IPO date is August 11, 1993 or later and zero otherwise
We estimate this regression for the sample of 177 small-deal issuances of

quali"ed small business stock and for the control sample of 51 larger IPOs for
which the e!ects of Section 1202 do not apply. Table 3 presents the results of
estimating Eq. (1) with the variable PostTax initially excluded and then included.
The intent of this presentation is to depict the impact of PostTax and whether its
inclusion in the regression a!ects the other coe$cients. A Breusch}Pagan (1979)
test rejects a null hypothesis of homoskedastic errors for the quali"ed small
business issuer sample and, as such, the t-statistics for the "rst two columns of
Table 3 are calculated based on White (1980). Perhaps because we focus the
analysis on a relatively homogeneous group of small deals by small companies
and select variables speci"c to this sample, the model exhibits strong explana-
tory power for the sample of quali"ed small business IPOs, with an adjusted
R of 13.2% prior to inclusion of the PostTax variable and 15.3% after its
inclusion. In contrast, Schultz (1993) reports a maximum adjusted R of 8.84%
in his study of unit IPOs.
For the 177 observations in the quali"ed small business issuer sample, the
coe$cient of the PostTax indicator variable (b ) is negative (!0.186) and

signi"cant beyond 5% (a one-tailed p-value of 0.0188). In addition to being
statistically signi"cant, this change in underpricing (approximately 19 percent-
age points) is also large in comparison with the average underpricing for the
pre-tax period (from Table 2) of 0.375. At pre-Section 1202 average proceeds of
$5.578 million (Table 2), this decline in underpricing corresponds to approxim-
ately $1 million of additional proceeds raised by a quali"ed small business stock
issuer subsequent to Section 1202. Overall, the results of estimating Eq. (1)
Table 3
Ordinary least squares regressions of IPO underpricing on control variables and an indicator
variable for whether the issue date is after the e!ective date of Section 1202. For the quali"ed small
business issuers, observations are the 177 Nasdaq-traded IPOs raising $10 million or less during
1993 and 1994 that "le a small-business SEC registration form (i.e., SB-1 or SB-2) and operate in
trades or businesses quali"ed by Section 1202; 40 are pre-Section 1202 and 137 are post-Section
1202. For the control group of larger IPOs, observations are the 51 Nasdaq-traded IPOs raising $60
million or more during 1993 and 1994 which operate in trades or businesses otherwise quali"ed by
Section 1202; 14 are pre-Section 1202 and 37 are post-Section 1202. Numbers in parentheses are
t-statistics and, when a Breusch-Pagan test rejects homoskedasticity beyond a 5% level, are
calculated using standard errors based on White (1980).
Variable Quali"ed small Control group

(predicted sign) business issuers of larger IPOs
Constant !0.398 !0.293 0.146 0.172

(!1.367) (!0.996) (0.952) (1.086)
Unit (#) 0.247 0.267 No No
(3.364) (3.584) variation variation
¸n(1#Age) (!) !0.002 !0.005 !0.001 !0.001
(!0.061) (!0.144) (!0.068) (!0.068)
Underwriter (!) !0.022 !0.021 !0.006 !0.005
(!2.731) (!2.838) (!0.545) (!0.457)
Assets/Proceeds (!) !0.008 !0.000 !0.006 !0.006
(!0.095) (!0.001) (!1.718) (!1.502)
%Retained (?) 0.758 0.842 0.188 0.175
(2.147) (2.387) (2.219) (2.014)
1/Price (#) 1.152 1.069 !1.245 !1.350
(2.281) (2.087) (!0.783) (!0.842)
Big6Auditor (!) !0.187 !0.202 No No
(!2.878) (!3.029) variation variation
PostTax (!) !0.186 !0.029
(!2.079) (!0.724)
Observations 177 177 51 51
Adjusted R 13.2% 15.3% 7.8% 6.8%
The variables are de"ned as follows:

Underpricing } (1st closing price!IPO price)/IPO price minus the daily return on the
OTC/Nasdaq Industrial Market Indicator from Standard & Poor's Daily Stock Price Record
Unit } one for a unit IPO (e.g., shares bundled with warrants) and zero otherwise
¸n(1#Age) } Natural logarithm of one plus the number of years from date founded or incorpor-
ated to IPO
Underwriter } a prestige ranking ranging from 0.0 to 9.0 (Carter et al., 1994)
Assets/Proceeds } pre-IPO total assets/IPO gross proceeds
%Retained } the percentage of voting common stock retained by pre-IPO shareholders and, in the
case of unit IPOs gives no value to warrants
1/Price } the reciprocal of the IPO o!er price per share or per unit
Big6Auditor } one if the issuer is audited by a Big 6 "rm and zero otherwise
PostTax } one if IPO date is August 11, 1993 or later and zero otherwise
Signi"cant beyond the 1% level (two-sided tests).
provide evidence consistent with the notion that IPO prices of quali"ed small
business stock issued after the e!ective date of Section 1202 are signi"cantly
higher (when contrasted with the "rst-day closing, tax-neutral price) than the
issue prices of similar companies' IPOs prior to Section 1202. We also estimate
Eq. (1) using raw (i.e., without market adjustment) and logarithmically trans-
formed underpricing, but the results are qualitatively the same with no changes
in statistical or economic inference.
In Appendix B we estimate what the change in underpricing would be if the
entire e!ect of the tax rate change were passed on to the issuing "rm in the form
of a higher stock price. Based on the computations in Appendix B, we estimate
that the amount of underpricing would decrease by approximately 19 percent-
age points if investors expected an annual growth rate for these investments of
40%. (Since empirical evidence shows actual returns from investments in small
IPOs are negative ex post, it is di$cult to estimate what annual growth rate
investors are expecting ex ante when making these investments.) Our "nding
that all of the expected future tax bene"ts from the tax rate change are re#ected
in higher stock prices contrasts with other implicit tax studies (e.g., Shackelford,
1991; Guenther, 1994; Engel et al., 1998; Erickson and Maydew, 1998), most of
which "nd smaller implicit tax e!ects.
For the control group sample of larger IPOs, the coe$cient for PostTax is
negative, but both statistically insigni"cant and less than one-sixth the size of
b for the sample of quali"ed small business IPOs. In contrast to the small IPO

sample, the results of estimating (1) on the control group of larger IPOs does not
provide evidence of a decline in underpricing during the period subsequent to
August 10, 1993. This suggests that the decline in underpricing during the
post-Section 1202 period evident in the Table 2 descriptive statistics results from
changes in the composition of the companies going public during this time
period and not due to an overall shift in IPO market conditions.
5.3. IPO underpricing pre and post Section 1202 } robustness checks
Because we use the coe$cient for the PostTax variable to estimate the e!ects
of a shift in the small-deal/small-business IPO market, it seems important to
consider whether PostTax is proxying for other temporal factors peculiar to this
Due to the evident parameter di!erences between the two samples (e.g., the absence of unit
o!erings, non-prestigious underwriters and non-Big 6 auditors from the sample of larger IPOs) and
our resulting reluctance to assume a constant disturbance variance, our research design does not
combine the samples for the purposes of conducting a Chow test of the di!erence between the
PostTax coe$cient from these two samples. If we allow for unequal variances, an asymptotic t test of
equality of the PostTax coe$cient between the quali"ed small business stock sample and the control
sample results in a t-statistic of !1.59 (one-tailed p of 0.056).
market segment. One possibility is that PostTax is measuring an overall change

in economic conditions, such as a shift in interest rates. The prime rate remained
unchanged at 6.0% for the period from July 2, 1992 to March 23, 1994 but, due
to a series of rate increases by the Federal Reserve, rose throughout the
remainder of 1994, ending the year at 8.5%. To pursue the possible e!ects of this
temporal explanation, we estimate a supplemental regression that includes as an
additional regressor the prevailing prime rate on the day of the IPO. The results
of this estimation provide no support for a relation between the prime rate and
underpricing and, moreover, inclusion of this prime rate variable has no eco-
nomic or statistical e!ect on the PostTax variable's sign or magnitude (its
coe$cient changes to !0.219 and its White-adjusted t-statistic increases to
!2.307). We also test to see whether the coe$cient for PostTax captures an
overall trend in small IPO prices unrelated to Section 1202 by running our
regression using only sample "rms that went public in 1994, with an arbitrarily
chosen dummy variable equal to one if the issue date is after June 30. For this
regression using 101 IPOs (43 of which occur after June 30, 1994) the coe$cient
for this dummy variable is positive. Therefore, the negative coe$cient on
PostTax in Table 3 does not appear to re#ect an overall trend of increasing prices
for small IPOs.
Because of the relatively small size of the primary sample (177 observations), it
is possible that the results reported in Table 3 are a!ected by extreme values. To
investigate whether our "ndings are robust to the presence of outliers, we
compute and plot the externally studentized residuals. Speci"cally, we generate
a normal probability plot by graphing these externally studentized residuals on
the y-axis and the n-score on the x-axis. Following Belsley et al. (1980) we
identify eight observations with absolute values of their externally studentized
residuals of two or greater. We eliminate these eight observations from the
sample and estimate Eq. (1) using the remaining 169 small-deal IPOs by small
business issuers. Similar to the results discussed, the results of this regression do
not diminish the statistical or economic importance of the PostTax variable
reported in Table 3 (its coe$cient changes to !0.109 and its White-adjusted
t-statistic increases to !2.394). We also run a regression for the full sample of
IPOs with observation-speci"c indicator variables for the eight IPOs with
externally studentized residuals of two or greater. The results of this regression
con"rm that these eight observations are in#uential in the sense that their
individual t-statistics show statistical signi"cance and (as expected) provide
identical results for the independent variables as the regression with 169 obser-
vations. In addition, we run another regression for these small IPOs that both
eliminates the outlier observations and controls for the prevailing prime rate on
the day of the IPO. Again, the results do not diminish the reported statistical or
economic importance of the PostTax variable (its coe$cient changes to !0.138
and its White-adjusted t-statistic increases to !2.829). Finally, we conduct two
additional robustness checks in addition to those discussed above. First, we use
the 25 "rms in nonqualifying industries (initially excluded from our sample) as

a control sample. Estimating our model on these "rms, both separately and also
combined with the qualifying sample (using dummy variables), results in a posit-
ive coe$cient on the PostTax variable, inconsistent with the results for the
qualifying sample. Second, we reestimate our regression after eliminating the 11
IPOs occurring in July and early August 1993 (immediately preceding the
e!ective date of Section 1202). The results after eliminating these "rms are
qualitatively similar to those reported.
6. Conclusion and contribution
We investigate how capital gains taxes a!ect stock prices by examining the
issue prices of small IPOs around the 1993 capital gains tax rate reduction for
quali"ed small business stock. Our results demonstrate that, after controlling for
underpricing, the issue prices of shares issued after August 10, 1993 (the e!ective
date of the tax rate change) are signi"cantly higher (compared with the "rst-day
trading price) than the issue prices of shares issued prior to that date. These
results appear robust to a number of alternative explanations, such as the
possibility of an overall shift in market conditions, outliers, changes in interest
rates, and changes in the number of IPOs going to market.
We interpret our results as providing evidence that the 1993 tax change is
associated with a signi"cant increase in the prices received for small IPOs,
a result that is consistent with the stated intent of Congress when the legislation
was introduced. These results make an important contribution to public policy
research in taxation by providing evidence that a tax law change targeted at
achieving a speci"c public policy objective } in this case reducing the cost of
capital for small businesses } can achieve its stated purpose. Although the results
of this study are only applicable to relatively small "rms, such "rms are an
important component of the national economy, and this study provides evid-
ence that helps us to better understand factors that a!ect the cost of capital for
these "rms.
Appendix A. Excerpt from Network Long Distance, Inc. IPO Prospectus
Network Long Distance, Inc. (SIC 4813 } Telephone Communications, ex-

cept Radio) "led an SB-2 registration statement with the SEC on December 14,
1993 and completed an IPO of its shares on the Nasdaq small-cap market on
February 24, 1994. Network, which had pre-IPO total assets of $3,322,977, sold
48% ownership for gross proceeds of $6,250,000. The following excerpt is from
page 33 of its o!ering prospectus.
On August 10, 1993, changes to the federal income tax code were enacted
which provide for the exclusion from a taxpayer's gross income of 50% of
capital gains on the sale of &quali"ed small business stock' which was pur-
chased from the issuer and has been held by an individual investor for more
than "ve years (Internal Revenue Code Section 1202). The Company believes
that as of the date of this Prospectus, the shares o!ered by the Company by
this Prospectus qualify as quali"ed small business stock.
Tax savings from the new provision may be substantial but are subject to
signi"cant restrictions. The August 10, 1993, tax changes increased the nom-
inal maximum federal tax rate on an individual's ordinary income to 39.6%,
while the nominal maximum rate on an individual's capital gains remains at
28%. The 50% exclusion provision of Section 1202 reduces this nominal
maximum rate on capital gains to 14% if the quali"ed small business stock is
held for more than "ve years. There are, however, restrictions as to which
every investor should consult his or her personal tax advisor. For example,
one-half the excluded amount (25% of the eligible gain) is a tax preference
item for the alternative minimum tax, allowable capital losses may be reduced
by the exclusion and certain phase-out provisions contained in other Internal
Revenue Code sections may increase the applicable tax rates.
In addition to restrictions on an investor's ability to claim the 50%
exclusion of Section 1202, there are standards which the Company must
continue to meet during the period the shares are held by the investors. The
statute is new and regulations interpreting it and establishing conditions on it
have not yet been adopted. The Company will use its best e!orts to comply
with all applicable requirements and conditions but no assurance can be given
that the Company will be able to comply or that the shares presently eligible
will continue to be eligible for the 50% exclusion.
Appendix B. Example of e4ect of tax rate change on underpricing
Assume that a "rm issues stock in an IPO and receives an amount P per

share, where the subscript &low' refers to a low investor tax rate on capital gains.
This price is expected to grow at a pre-tax rate of g per year for n years, at which
time the investor will sell the stock and pay a capital gains tax at rate t. The
shareholder will receive P (1#g)L and pay tax of [P (1#g)L!P ]t, so the

after-tax proceeds are:
P (1#g)L![P (1#g)L!P ]t"P [(1#g)L(1!t)]#P t.

Expressed as a return, this becomes
P [(1#g)L(1!t)]#P t!P P [(1#g)L(1!t)]#P t
" !1.
P P

Suppose a purchaser of the stock on the day it begins trading also expects to
receive P (1#g)L at the end of n years, but will pay tax at the high rate 2t.

What price (P ) would the high-tax-rate purchaser pay for the stock to earn

the same after-tax return as the IPO investor who pays P ? The after tax return

is:
P [(1#g)L(1!2t)]#P 2t!P P [(1#g)L(1!2t)]#P 2t
" !1.
P P

Setting this return equal to the return of the IPO investor who pays P results

in the following equation:
P [(1#g)L(1!t)]#P t P [(1#g)L(1!2t)]#P 2t
" ,
P P

(1#g)L(1!t)#t"[P /P ](1#g)L(1!2t)#2t,

(1#g)L(1!t)"[P /P ](1#g)L(1!2t)#t,

(1#g)L(1!t)!t
"[P /P ](1!2t),
(1#g)L
(1#g)L(1!t)!t
"P /P . (B.1)
(1#g)L(1!2t)
The following parameter values are consistent with the provisions of Section
1202 and the statutory capital gains tax rates in e!ect in 1993 for individuals:
n"5; t"0.14; 2t"0.28. Substituting these values into (B.1) and assuming
a value of g equal to 20% results in a value for the ratio of P to P equal to

1.1163.
The mean underpricing for the sample period prior to the 1993 tax rate
change (from Table 2) is 0.38. Using this value and the formula for underpricing
results in the following equation:
P !P
"0.38,
p

where P is the price paid by an investor for the IPO share and P is the market

price on the "rst trading day. This is equivalent to P /P "1.38 or P "1.38P .

How will this relation be a!ected by the tax rate change? The price on the "rst
trading day (P ) is not expected to change, since investors who buy in the market

on the "rst day do not receive the Section 1202 bene"t. Therefore, P is expected

to remain equal to 1.38P .

However, the price paid by the IPO investor is expected to change because of
the tax rate reduction. If P represents the high-tax-rate price, then the IPO

investor facing the lower tax rate would be willing to pay an amount equal to
1.12 P based on the value assumed for Eq. (B.1) above. Using these values in the

Table 4
Expected P /P Expected change

growth (g) in underpricing
0.20 1.1163 !0.15

0.30 1.1421 !0.17
0.40 1.1583 !0.19
0.50 1.1688 !0.20
underpricing equation results in an underpricing of

[1.38P !1.12P ]/1.12P "0.23.

This means that, using the parameter values above, if IPO investors pass on
all of the tax savings to the "rm in the form of a higher IPO price, the
underpricing would change from its pre-tax-change value of 0.38 to a post-tax-
change value of 0.23 for a change in underpricing of !0.15.
Assuming di!erent values for expected growth in Eq. (B.1), but keeping the
other parameter values the same, results in P /P and the expected change in

underpricing given in Table 4.
Our estimates of the potential tax e!ect are based on an investor facing the
regular tax rate. However, one-half of the excluded gain under Section 1202 is
treated as a &tax preference' item for the Alternative Minimum Tax (AMT). An
investor facing the AMT would therefore have 75% of the gain taxed (compared
with 50%), and would face a tax rate of 21% (compared with 14%) on the gain.
If the marginal investor in quali"ed small business stock faces the AMT, then
our estimates of the expected decrease in underpricing would be much lower
than those presented here. There is no way for us to ascertain whether investors
in small IPOs face the AMT.
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Capital Gains Tax Rates and The Cost of Capital For Small Business Evidence From The IPO Market

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Capital Gains Tax Rates and The Cost of Capital For Small Business Evidence From The IPO Market

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Journal of Financial Economics 53 (1999) 385}408

Capital gains tax rates and the cost of capital

JEL classixcation: G32; H25

Keywords: Small business; Initial public o!erings; Capital gains tax

* Corresponding author. Tel.: #1-860-486-3020; fax: #1-860-486-4838.

2. Taxation of gains of qualifying small business stock

1. any trade or business involving the performance of services in the "elds of

3. Research design + controlling for IPO underpricing

4. Sample selection and variable measurement

4.1. Sample selection

Panel A: Small IPOs by qualixed small business issuers

Firm-commitment, Nasdaq initial public o!erings raising $10 million 270

Panel B: Control group of larger IPOs

Firm-commitment, Nasdaq initial public o!erings raising $60 million 59

4.2. Investors in small IPOs

To identify our primary sample of IPOs by quali"ed small business issuers, we

4.3. Data sources and variable measurement

5.1. Descriptive statistics

Variable Quali"ed small business issuers Control group of larger IPOs

Total Pre-tax Post-tax Total Pre-tax Post-tax

Underpricing Mean 0.290 0.375 0.265 0.102 0.140 0.087

The variables are de"ned as follows:

proceeds of $4,843,750. After deducting an 8% underwriter discount, Sunbelt's

We estimate this regression for the sample of 177 small-deal issuances of

Variable Quali"ed small Control group

Constant !0.398 !0.293 0.146 0.172

The variables are de"ned as follows:

market segment. One possibility is that PostTax is measuring an overall change

the 25 "rms in nonqualifying industries (initially excluded from our sample) as

6. Conclusion and contribution

Appendix A. Excerpt from Network Long Distance, Inc. IPO Prospectus

Network Long Distance, Inc. (SIC 4813 } Telephone Communications, ex-

Appendix B. Example of e4ect of tax rate change on underpricing

Expected P /P Expected change

0.20 1.1163 !0.15

underpricing equation results in an underpricing of

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