The influence of top management team heterogeneity on the capital raised through an initial public offering.

A significant body of research exists on the top management teams (TMTs) of established firms and specifically on the heterogeneity of TMTs of established firms. Little research exists, however, on the heterogeneity of TMTs of firms in the early stages of their existence. In this study, I examine the relationship among TMT heterogeneity and the capital raised by the firm through its initial public offering (IPO). I argue that TMT heterogeneity provides a signal to potential investors about the quality of the IPO and hence is associated with greater capital accumulations. My findings suggest that heterogeneity in the TMT's functional background and educational background is associated with greater capital raised through an IPO.

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The initial public offering (IPO) of a firm's stock is a significant time in the life of the firm. It is a point of transition from the private to the public domain (Certo, 2003). Although firms preparing for an IPO often attract investors' attention, the attention often does not result in investment because IPO firms have little or no operating history, lack a publicly available record for their stock price, and are riskier than larger, more established firms (Beatty & Zajac, 1994; Nelson, 2003; Welbourne & Andrews, 1996). They face a liability of market newness (Certo, 2003).

IPOs have been the focus of extensive research, and many theoretical perspectives have been used to study IPOs including agency theory, resource dependence theory, and signaling theory (Beatty, 1989; Brav & Gompers, 1986; Carter, Dark, & Singh, 1998; Certo, 2003; Daily, Certo, Dalton, & Roengpitya, 2003; Deeds, DeCarolis, & Coombs, 1997; Lester, Certo, Dalton, Dalton, & Cannella, 2006; Megginson & Weiss, 1991; Pollock, Porac, & Wade, 2004; Sanders & Boivie, 2004). Signaling theory has been used quite extensively in part because it captures the information asymmetry and uncertainty surrounding the IPO (Certo, 2003). IPO firms signal potential investors to demonstrate that they are economically rational investments and that they will perform well in the future (Certo, 2003; Deeds et al., 1997; Zimmerman & Zeitz, 2002). Firms that demonstrate that they are economically rational investments can gain legitimacy, and legitimacy provides firms access to the resources they need to survive and grow (Zimmerman & Zeitz, 2002). Specific firm characteristics used as signals include underwriter's reputation, equity retained in the firm, auditor reputation, firm size, venture capital (VC) equity invested in the IPO firm, and top management team (TMT) prestige (Carter & Manaster, 1990; Certo, 2003; Daily et al., 2003; Downes & Heinkel, 1982; Lester et al., 2006; McBain & Krause, 1989).

Certo (2003) and Lester et al. (2006) suggest that TMT characteristics signal the firm' s legitimacy and may enable the firm to access capital. TMT characteristics have been argued to play an important role in strategic decision making and firm performance (e.g., Hambrick & Mason, 1984). A specific aspect of TMT research has examined TMT heterogeneity and its relationship to firm performance in established firms (Glick, Miller, & Huber, 1993; Hambrick, Cho, & Chen, 1996; Kilduff, Angelmar, & Mehra, 2000; Lyon & Ferrier, 2002; Simons, Pelled, & Smith, 1999). TMT heterogeneity is typically measured in terms of observable characteristics such as functional background, education, tenure, and age, which serve as proxies for psychological attributes that influence strategic choices and firm performance (Hambrick & Mason, 1984). Published research offers support for the claim that the breadth of perspective, experience, knowledge, insight, etc., provided by a heterogeneous TMT is positively related to firm performance in established firms (e.g., Hambrick & Mason, 1984; Kilduff et al., 2000) and the importance of a balanced team in the early stages of funding (Macmillan, Siegel, & Narasimha, 1985; Roure & Maidique, 1986). Such research suggests that a heterogeneous TMT would be beneficial to the ability of the firm to raise capital through an IPO.

Despite the wealth of literature on IPOs and evidence that TMT characteristics influence firm performance, there is relatively little research examining the influence of the TMT characteristics on IPO performance (e.g., Carpenter, Pollock, & Leary, 2003; Deeds, Mang, & Frandsen, 2004; Filatotchev & Bishop, 2002; Finkle, 1998; Lester et al., 2006; Nelson, 2003; Sanders & Boivie, 2004; Welbourne & Cyr, 1999). Carpenter et al. (2003) found that governance and stakeholder characteristics influenced global risk taking of IPO firms. Deeds et al. (2004) examined the influence of firm-level legitimacy, including TMT credentials (i.e., graduate business education), upon the capital raised through an IPO. They found that firm-level legitimacy significantly influenced the amount of capital raised but that TMT credentials were not significantly related to capital raised. Filatotchev and Bishop examined underpricing of IPOs in relationship to board composition and ownership and found that the proportion and extraorganizational ties of nonexecutive board members were negatively related to underpricing of IPOs. They also found that the diversity and equity holdings of the board were negatively related to the experience and stock ownership of the TMT. Nelson found differences in the governance and ownership between founder-led and nonfounder-led IPO firms. Specifically, founder-led firms received higher stock price premiums than nonfounder-led firms. Sanders and Boivie examined corporate governance characteristics as indirect indicators of potential qualitative differences among IPO firms and found that the market valuation of IPO firms was significantly related to such characteristics. Furthermore, Welbourne and Cyr found that stock price was positively related to the presence of a human resource executive on the TMT in fast-growing and small IPO firms.

I could identify only two studies that examined TMT demographic characteristics as IPO signals (Finkle, 1998; Lester et al., 2006) and only one that addressed corporate governance as an IPO signal (Sanders & Boivie, 2004). Finkle examined Chief Executive Officer (CEO) and board of directors characteristics of biotechnology IPOs and found that CEO and director expertise were positively related to the amount of capital raised. Lester et al. examined TMT prestige and found that it was significantly related to investor valuations of IPO firms. Specifically, they found that educational prestige was positively related to investor valuations. Sanders and Boivie examined corporate governance as an IPO signal (stock-based incentives, board structure, institutional and blockholder stock ownership, and VC involvement) and found that market valuation was significantly related to these characteristics.

The research question I addressed in this paper is, "Does TMT heterogeneity influence the amount of capital the firm raises through its IPO?" The focus of the paper is on the role that TMT characteristics play in raising capital, i.e., a resource critical to the firm's survival and growth (Deeds et al., 1997, 2004; Finkle, 1998; Gulati & Higgins, 2003), by signaling its legitimacy to potential investors (Certo, 2003; Lester et al., 2006). I argue that heterogeneity provides a signal to potential investors about the future prospects of the IPO and hence is associated with greater capital accumulations. I examine the relationship between four types of TMT heterogeneity--functional background, educational background, age, and tenure--and the amount of capital raised at IPO. To test the theory, I examine data from 172 software firms that underwent an IPO (between January 1, 1993 through December 31, 1997). Data were collected on the TMT, the firm, and the capital raised through an IPO. I begin with a review of literature on signaling theory and TMT heterogeneity, followed by an analysis of data. I conclude with a discussion of results.

Literature Review

The IPO process is a complex one. The firm transitions from a privately owned and managed firm to one that is publicly owned (Certo, 2003). Firms undertake an IPO primarily "to infuse a significant amount of investment capital into the firm" (Deeds et al., 1997, p. 31). The success of an IPO can be determined by the amount of capital that flows into the firm, and this amount depends upon the favorable evaluation of the firm by the financial market (Deeds et al., 2004). The amount of capital the firm can raise through an IPO involves negotiations between the lead underwriter and the firm. The potential for raising capital is not only based upon financial characteristics such as assets, earnings, book value, etc. (Welbourne & Andrews, 1996) but also upon intangible assets (Deeds et al., 1997), such as the TMT (Certo, 2003; Finlde, 1998; Nelson, 2003; Welbourne & Cyr, 1999). In this paper, I argue that the TMT characteristics are signals sent by the IPO firm to potential investors about the future prospects of the firm and hence might be associated with greater capital accumulations. Signaling Theory

Signaling theory is based on the need to resolve information asymmetry in decision making (Spence, 1974). Initially used to describe the hiring process, "the basic premise of signaling theory is that all of the necessary information for an organization to predict an individual's future productivity is usually unobtainable" (Hannon& Milkovich, 1996, p. 405). Therefore, managers need to rely on other items (termed signals) to indicate that the individual has the potential to be a productive member of the organization.