In order for capitalization to efficiently occur in a primary market, a secondary market is necessary.
Only if you assume that initial capitalisation comes from either small investors or organisations who make it their business to capitalise new enterprises with the intention of selling their commitment on the secondary market.
However, what we increasingly see is that firms are initially capitalised out of retained earnings or by enclosing commons for sale (companies spinning off subdivisions, technology commercialisation piggybacking on university R&D, pork barrel projects offering a protected environment with guaranteed revenue streams, etc.). These are generally justified on the basis of the prospective revenue stream, not the prospective resale value.
It's usually better in a number of ways (as we've all recently learned regarding private credit default derivatives) to have a market that is regulated by society in some way instead of just private, back-room deals.
In the particular case of equities, however, your ability to sell depends on the sovereign's will and ability to enforce your buyer's claim. There is no physical product to hide, smuggle or transact in. Just as a simple decision to not enforce over-the-counter CDS contracts would kill the CDS market stone dead in an instant.
- Jake If you only spend 20 minutes of the rest of your life on economics, go spend them here.
No, I only need to assume that at least some capitalisation comes from people who intend to resell at least some of their commitment relatively quickly in a secondary market. If their money is left on the table, and it is a significant amount of money, it's inefficient. My claim would be that alot of venture capital, particularly in risky investments such as technology start-ups and artistic ventures, require the ability to realize a profit wihin a very short time horizon. Risk becomes reduced as a firm or industry matures, and the risk-seeking investors who require higher returns to justify the risk they take need to be able to exit and get replaced by risk-averse investors with lower return expectations. Without a secondary market of risk averse investors -- the regulated stock markets, there would be significantly less venture capital available for innovative work.
No, I only need to assume that at least some capitalisation comes from people who intend to resell at least some of their commitment relatively quickly in a secondary market. If their money is left on the table, and it is a significant amount of money, it's inefficient.
Fortunately, that's an empirical question: How much investment into emerging companies came from investors, as opposed to securing a revenue stream from the customers before launch? Unfortunately, I don't have the data at hand to answer that question.
Have to be a damn fool to buy into an IPO but there seems to be plenty of damn fools running around ... and we know what happens to their money!
US stock markets operate under the Greater Fool Theory.
securing a revenue stream from the customers before launch
Ouch. That's tough enough when you have a going concern and an existing product - for example, a manufacturer of bespoke machine tools will be lucky to get 10% up front, the rest paid in installments as milestones are hit over the project period (say, 18 mo.). But an established company can often get financing to cover the cash flow.
It would be damn near impossible for a startup with no track record to finance development and manufacture of an unproven product through advanced sales (unless they're very good at marketing to morons). The fact is that what we're experiencing right now is a top-down disaster. -Paul Krugman
