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Weekly UpdatesOne of the most important events in the life of an entrepreneurial firm is when it undergoes an initial public offering (IPO). Combining signaling theory with research on the role of information asymmetry in pricing of IPOs this study examines the performance outcomes of two distinct types of agency conflicts at the time of the IPO: adverse selection and moral hazard. Empirical results show a curvilinear (U-shaped) relationship between founders' retained equity and underpricing. This suggests that founders' retained ownership in an entrepreneurial IPO limits adverse selection problems and the associated IPO underpricing; however, at some point entrepreneurs' investment and risk become so great that entrepreneurs may no longer act rationally and moral hazard increases. Empirical findings also indicate that the retained ownership of business angels has a stronger mitigating effect on adverse selection and moral hazard problems than do venture capitalist investors.
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An initial public offering (IPO) can provide an entrepreneurial firm with critical resources for its future expansion. It can also provide the entrepreneur with the first substantive access to cash from their investment of time and resources in the entrepreneurial effort. Underpricing of the stock at the IPO, the difference between the initial price at which a firm's stock is offered and the closing price of the stock on the first day of trading is a major concern to the entrepreneurial firm and to the entrepreneur since it represents value the market ultimately sees in the stock but which the firm/entrepreneur did not obtain when the stock was first offered for sale (Daily, Certo, Dalton, & Roengpitya, 2003; Ibbotson, Sindelar, & Ritter, 1988). (1) Previous studies indicate that governance characteristics of IPO such as the presence of a founding entrepreneur ownership structure (Brennan & Franks, 1997; Filatotchev & Bishop, 2002), and the presence of "certifying" investors such as private equity investors (Daily et al.) can signal the expected value of an IPO firm which in turn limits underpricing. But the prior research efforts have examined each of these characteristics individually. As yet, there is very little integrative research on the simultaneous effect of these corporate governance characteristics on the IPO underpricing.
This paper examines IPO underpricing in a sample of U.K. entrepreneurial IPOs where founders retain a significant ownership stake. The study combines both IPO signaling and agency perspectives (Jensen & Meckling, 1976; Sanders & Boivie, 2004). Signaling research suggests that underpricing can be reduced by idiosyncratic signals through which an IPO team conveys information about the firm's quality to outside parties (Sanders & Boivie). Agency-based studies argue that these signals may be associated with the firm's ownership structure and the governance roles of early stage investors (Barry, Muscarella, Peavy, & Vetsuypens, 1990; Filatotchev & Bishop, 2002).
This paper extends IPO studies in four ways. The first and most significant contribution is the exploration of agency conflicts, not as a unitary concept as has been done in prior research, but instead as two distinctive types of agency problems (adverse selection and moral hazard). We analyze the effectiveness of firm-level signals associated with ownership patterns with regard to each of these types of agency problems within entrepreneurial IPO firms. Second, in contrast with prior research, which tends to either treat outside investors such as private equity investors as a unitary group, or to not define exactly who is included in such designations (i.e., Brav & Gompers, 2003), we compare the governance roles of two types of IPO private equity investors-"formal" (venture capitalists) and "informal" (business angels) private equity investors. A third contribution is that we develop our arguments in the context of founder entrepreneurs who lead IPOs; that is, we examine IPOs where the original founders retain equity stakes and board positions. This environment is unlike the Berle and Means model of agency conflicts in public companies where there is typically widely dispersed ownership. Instead, this environment offers a setting where the founders of IPO firms are typically the largest shareholders and retain majority control even after the IPO (Wasserman, 2003). Therefore, these firms provide a unique laboratory to test various assumptions of the agency and signaling perspectives since potential problems of adverse selection and founders' opportunism may be particularly explicit in this important segment of IPO market.
To test the research hypotheses, we use a sample of IPOs in the United Kingdom. As result, the last contribution of the paper is to take IPO research outside the United States context that helps to generalize our understanding of IPO agency problems in different country environments. This contribution is greater than simply looking at IPOs in a different country. The U.K. private equity industry is different from the U.S. industry in that venture capital (VC) firms focus on later stage ventures and management buy-outs. At the same time, the U.K. has developed communities of business angels that are playing an increasingly important role in financing new ventures (Freear, Sohl, & Wetzel, 2002). The institutional aspects of the U.K. IPO market provide an opportunity to develop a more general analysis of entrepreneurs' signaling strategies in the context of public listings.
Review of Literature
Information asymmetries, or differences in information between the various parties to the listing process, including the IPO firm, banks-underwriters, entrepreneur, and external investors have been the foundation of prior investigations of underpricing (Ritter & Welch, 2002, p. 1807). Results of information asymmetry are two distinctive types of agency problems--adverse selection and moral hazard. To illustrate adverse selection agency conflict, a manager may not accurately reveal all he/she knows about a firm. Specifically, at IPO this may take the form of overly optimistic estimates of the firm's revenues by one of these parties. These overly optimistic estimates can increase the expected value of the firm and in turn increases the rewards from the IPO and are a type of adverse selection agency conflict (Stein, 1998). Moral hazard problems emerge when information asymmetries make it is possible for managers to shirk their duties and not act at maximum efficiency and effectiveness for the firm (Nygaard & Myrtveith, 2000). As a result of these information asymmetries, there are potential agency costs when a firm experiences an IPO since managers may not reveal actions within the firm or do not take certain actions that maximize the firm benefit (Sanders & Boivie, 2004).
At IPO, investors recognize the potential impact of the agency costs associated with information asymmetries, and protect themselves in part through underpricing of the IPO. However, the IPO team may use signals that allow potential investors to better understand the true value of the firm and the risks of agency problems which in turn can reduce underpricing (Sanders & Boivie, 2004). A signal involves a costly action, which because of its cost is not likely to be done in settings where there is a low-quality entrepreneurial venture (Spence, 1973). But signals are not universal in addressing all issues. For example, adverse selection agency conflict needs signals that validate that the entrepreneurial firm is presenting accurate information while moral hazard agency conflict needs signals that the entrepreneurial firm is being appropriately monitored.
Within this framework, our research is focused on two types of potential signals. Prior research recognizes that entrepreneurs themselves can provide signals that are difficult to imitate and that provide an indication of the IPO firm's value (Brennan & Franks, 1997). Another potent type of signal comes from outside investors in the firm. Such private equity investors "certify" the potential value of the IPO firm and differentiate it from other listed firms (Daily et al., 2003). In this paper, we build on previous research and analyze how these two broad categories of signals (entrepreneur-related and outside investors) act in tandem and affect both adverse selection and moral hazard problems in IPO firms.
Entrepreneur-Founder
Previous studies that have focused on the entrepreneur himself or herself as a signal have principally been concerned with the effects of their retained share ownership on investors' perceptions of possible agency costs (see Brennan & Franks, 1997, for a discussion). Since entrepreneurs have superior information about their ventures, they may be reluctant to fully disclose proprietary information to potential IPO investors. This may result in potential adverse selection costs (Shane & Cable, 2002). Alternatively, entrepreneurs can engage in opportunistic and self-seeking behavior when they disclose information, which may lead to moral hazard costs (Jensen & Meckling, 1976).
Signaling theory suggests that entrepreneurs may mitigate the agency problems by taking actions that will prove to be costly to those entrepreneurs in lower quality ventures. In other words, the cost of actions undertaken by entrepreneurs in high quality IPO firms is high enough to discourage entrepreneurs from employing them in low quality IPO firms (Downes & Heinkel, 1982). One potentially costly action that can signal that entrepreneurs expect high value from the venture is by retaining significant ownership in the venture after the IPO (Leland & Pyle, 1977).
An IPO represents the first and most important "liquidity event," which the founders and early stage investors can use to appropriate a proportion of wealth associated with the venture (Daily et al., 2003). After the IPO, the founders' and early stage investors' shareholdings are usually determined by a lock-up agreement that prevents sales of shares for a specified period of time, but they have a considerable discretion in terms of how many shares they would like to retain in the process of listing. In addition, there is evidence that there are often large amounts of stock released after the IPO as covenants of the lock-up agreement are waived (Brav & Gompers, 2003). Therefore, although entrepreneurs look to get outside investors to invest in the venture at the time of an IPO, they will seek to maintain the maximum level of ownership if they believe the venture will ultimately have a high positive value. This action is costly for the entrepreneur since she/he forgoes diversification of his/her personal portfolio (Dowries & Heinkel, 1982, p. 3). Thus, high level of ownership by the entrepreneur signals that she/he believes there is high value in the venture, and this signal in turn reduces the adverse selection problem for IPO investors (Prasad, Bruton, & Vozikis, 2000). This will also lead to greater alignment of interest with other investors, and signals that the entrepreneur will aggressively seek to make decisions that maximize the value of the venture (Jensen & Meckling, 1976). Thus, the ownership level of the entrepreneur also reduces the moral hazard problem.
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