A clear corporate strategy communication can be a signal to
financial analysts and public investors at the time of an initial public
offering (IPO). This study examines IPO prospectuses of 57 biotechnology
firms listed on the NASDAQ between 1997 and 2002. Using regression
analysis, this article shows that the clarity, intensity, and
consistency of the corporate strategy signal are not strong enough to
affect the 1st-day initial returns. However, consistent communication of
a prospector strategy negatively impacts 30-day initial returns, whereas
consistent communication of a defender strategy positively impacts
30-day initial returns.
Keywords: corporate strategy; communication; IPO; market signal
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Uncertainty characterizes the time surrounding an initial public
offering (IPO). It is difficult to predict how the market will perform
following the IPO date (Ibbotson, 1975). Similarly, determining a fair
market value of the firm is complex because of the newness of the firm
to the market (Certo, 2003) and the entrepreneurial nature of some IPO
firms (Certo, Daily, & Dalton, 2001; Daily, Certo, Dalton, &
Roengpitya, 2003). Researchers attribute this uncertainty to information
asymmetry or knowledge gaps between informed and uninformed investors
(Ibbotson, 1975; Ibbotson, Sindelar, & Ritter, 1988; Rock, 1986).
Although some debate exists about which investors are more informed,
this article takes the positions that (a) IPO issuers are more informed
than public investors and (b) institutional investors are more informed
than small investors (Daily et al., 2003; Ritter & Welch, 2002).
Extant research has applied signaling theory widely to address this
information asymmetry dilemma (Daily et al., 2003). Signaling theory
suggests that certain indicators provide signals to potential investors
about the capabilities of the IPO firm and therefore the likely future
value of the firm (Deeds, DeCarolis, & Coombs, 1997). Research
reports that credible communication outlining important information at
the time of an IPO can reduce the information asymmetry between IPO
issuers and investors. So far, the types of information included in
research are (a) the composition of the board; (b) the reputation of the
underwriter; (c) the source and amount of venture capital; (d) the
nature of the firm's intellectual capital; and (e) the ability of
those within the firm to manage knowledge. Credible communication also
helps IPO issuers reduce the information asymmetry between informed and
uninformed investors and maximize the value of going public (Azarmi,
2002; Bukh, Nielsen, Gormsen, & Mouritsen, 2002; Carter, Dark, &
Singh, 1998; Certo et al., 2001; Megginson & Weiss, 1991; Neck,
Welbourne, & Meyer, 2000; Rosenstein & Wyatt, 1997). One
possible explanation for the link between credible communication and the
value of an IPO is that shareholders increasingly seek strategic
information (such as the information described above) in order to
explain an investment opportunity (Brown, 1997; Desai, 2000; Higgins
& Diffenbach, 1989; Neck et al., 2000).
A group of studies reports that communication on corporate strategy
received by the stock market has a significant impact on the value of
shares in the market (Day & Fahey, 1990; Higgins & Bannister,
1992; Higgins & Diffenbach, 1985; Parnell & Wright, 1993).
However, we are not aware of any published studies that empirically
examine the relationship between corporate strategy communication and
returns to IPO investors on both the 1st day and in the short-term
after-IPO market (e.g., 30-day returns). This oversight is surprising
because the communication of corporate strategy has been extensively
argued to affect the market price and shareholder value in the long
after-IPO market (e.g., a year or more after the event; Day & Fahey,
1990; Desai, 2000; Higgins & Bannister, 1992; Higgins &
Diffenbach, 1985). This article proposes that the communication of
corporate strategy at the time of an IPO provides cues to assist
analysts and investors in deciding whether or not to invest in an IPO
firm. This view becomes particularly important when the IPO firm first
goes public because IPO managers must find a mechanism to communicate
their firm's quality in order to reduce the ex ante uncertainty and
thus reduce the need to discount the stock price to attract
less-informed investors (Daily et al., 2003). Through the credible
communication of corporate strategy, investors and analysts will better
understand a firm's strategic posture, activities, and plans and
then be able to assess the fit between internal resources, the
firm's corporate strategy, and the external environment in which
the firm operates. Thus, by obtaining strategic information, investors
and analysts are in a better position to infer the potential value of
the firm (Day & Fahey, 1990). This article proposes a significant
advantage for an IPO firm that provides as part of IPO documentation an
overview of the firm's corporate strategy as "information
cue" (Miles & Snow, 1978).
Underpricing is generally defined as the difference between the
price at which the firm's stock was initially offered and the
stock's closing price on the 1st day of trading (Ibbotson, 1975;
Ibbotson et al., 1988; Ritter, 1998). Although a number of theoretical
explanations (e.g., risk-averse underwriter, information asymmetry, and
bandwagon) exist for IPO underpricing, this article adopts the
information asymmetry approach. Therefore, we assert that if IPO
communication is credible, then underpricing will be minimized and so
the 1st-day returns will be close to expected returns (Certo et al.,
2001; Ritter, 1998).
Of the studies that examine the relationship between an IPO event
and investor returns, most focus on the returns on the 1st day of an IPO
event as an indicator of information asymmetry in the market (Bukh et
al., 2002; Certo, 2003; Certo et al., 2001; Durukan, 2002; Megginson
& Weiss, 1991; Neck et al., 2000; Rosenstein & Wyatt, 1997).
However, we also propose that returns at some stage after an IPO event
should be examined because of market instability and opportunistic
behavior surrounding the IPO event. By taking a slightly longer term
view (in this case, 30 days after an IPO event), this research controls
for the effect of opportunistic investors who order stocks before the
1st day and then on-sell these stocks soon after (Finkle & Lamb,
2002; Ritter, 1991, 1998). Accordingly, this research includes both
investor returns on the 1st day and 30 days after an IPO event to
examine the effect of the strategy signal.
This article is structured as follows: We begin by presenting a
theoretical framework, based on market signal and corporate strategy
theory, before presenting research hypotheses. Next, the population of
biotechnology IPO firms used in the nominated time period is described
and an overview of the content analysis method used for data analysis is
provided. Finally, we discuss our findings and the implications of these
for both research and practice.
LITERATURE REVIEW
Corporate Strategy and Shareholder Value
Corporate strategy can influence the performance of an organization
(Mintzberg, Lampel, Quinn, & Ghoshal, 2003). With a sound corporate
strategy, a firm can consistently create high value through its
integrated business activities; with a weak corporate strategy, the
value of a firm's business activities deteriorates (Goold,
Campbell, & Alexander, 1994). Thus, shareholders see corporate
strategy as an important proxy for the likely value of the firm (Day
& Fahey, 1990).
Corporate strategy provides a navigation map to the investors and
analysts (Desai, 2000). The effective communication of corporate
strategy is important because it builds relationships with and
encourages the involvement of investors and analysts (Bukh et al., 2002;
Desai, 2000). Effective communication of corporate strategy can also
enhance shareholder satisfaction (Higgins & Bannister, 1992) and
build employee morale (Burgi & Roos, 2003). Credible communication
further enables managers within the firm to crystallize and clearly
articulate corporate strategy to employees and investors alike. This, in
turn, helps managers reinforce or redevelop strategic choices (Burgi
& Roos, 2003) and increases the confidence stakeholders place upon
the strategic ability of management (Mintzberg et al., 2003).
Although those within the firm endeavor to better communicate
corporate strategy, evidence suggests that shareholders also seek to
better understand the strategic posture of the firm (Day & Fahey,
1990; Rapport, 1981). Possible explanations for this phenomenon are as
follows: (a) The environment in which many firms operate is ever more
dynamic and competitive (Brown, 1997; Lynch, 2000; Mintzberg et al.,
2003; Rapport, 1981); or (b) traditional financial measures are no
longer comprehensive indicators of internal management capabilities
(Beattie, 1999; Eccles, Hertz, Keegan, & Philips, 2001). This second
point is especially relevant with IPO firms, which often lack financial
history; furthermore, any history might be distorted by a long R&D
stage and negative profit (Cumby & Conrod, 2001).
Corporate Strategy as an IPO Market Signal
Spence (1973, 1974) introduces the concept of a market signal when
studying the labor market to explain an observable proxy that can be
used to predict unobservable attributes of the issue under examination
(Spence, 1973). As an example, Spence (1973) argues that employers could
use the education level of a job applicant as a signal of the likely
productive capability of that applicant (Spence, 1973). Thus, market
signals reduce the amount of information asymmetry between buyers and
sellers and, accordingly, improve the effectiveness and efficiency of a
market (Engers, 1987). For a market signal to work, the key requirements
are that information (a) is observable, (b) is difficult to alter, (c)
is costly to produce and change, (d) is difficult to imitate, (e)
reduces asymmetry between signal senders and receivers, and (f) is
persistent (Riley, 1975; Spence, 1973, 1974).
This study classifies IPO prospectuses as a market signaling
activity because the IPO prospectus attempts to reduce information
asymmetry between those buying and selling stocks in the IPO firm. Based
on market signaling literature, the following observations are made to
support the positioning of corporate strategy communicated from IPO
prospectuses as a market signal. First, the corporate strategy of an IPO
company is an observable and easy-to-notice piece of information from an
IPO prospectus (Marino, Castaldi, & Dollinger, 1989). The IPO
prospectus provides greater detail about a company's strategic
planning, products/markets, and management structure than any other form
of communication (e.g., press releases, road shows, advertisements) and
so has the potential to capture investors' attention at the time of
the IPO event. Prospectuses are widely used by investors and their
reference groups (e.g., analysts) to understand the likely value of the
firm (Cumby & Conrod, 2001; Marino et al., 1989; Song, Rhee, &
Adams, 2001).
Second, prior to publication, the strategic information
communicated in an IPO prospectus can be altered by managers (Meek,
Roberts, & Gray, 1995). Once published, however, managers need to
implement those strategies in order to win the ongoing trust from
investors and analysts. Third, the establishment and communication of a
firm's corporate strategy are costly, risky (Porter, 1980), and
difficult to imitate. Due to the nature of the corporate strategy in
addressing multiple dimensions of a business, its formulation and
implementation are a gradual and costly process (Doty, Glick, &
Huber, 1993; Miles & Snow, 1978; Parnell & Wright, 1993). A
strategy will be seen as credible when there is a perceived fit between
the strategy itself and the context within which the firm operates, for
example, the product/market environment, technology environment, and
management structure (Doty et al., 1993; Miles & Snow, 1978). The
requirement for fit makes imitation by competitors difficult. A
"hurried" announcement of a corporate strategy may lead to a
negative reaction from the market because investors and their reference
groups will evaluate the firm's performance based on the announced
strategic plan (Day & Fahey, 1990; Higgins & Bannister, 1992;
Higgins & Diffenbach, 1985, 1989).
Fourth, strategic information asymmetry exists between the
management team in an IPO firm and outside investors in the IPO market
(Beatty & Ritter, 1986; Rock, 1986). This information asymmetry can
be reduced when investors accept corporate strategy as a cue. Through
the clear identification of corporate strategy, investors and analysts
can better understand a firm's strategic posture, activities, and
plans and assess the fit between internal resources and the external
environment in which the firm operates. Investors and analysts are
therefore in a better position to infer the potential value of the firm,
taking into account other financial performance data (Day & Fahey,
1990). In addition, the information disclosure of a public firm
following an IPO is persistent (Baruch, 1992) and either reinforces or
diminishes the signal. This article proposes a significant advantage for
an IPO issuer that provides an overview of the firm's corporate
strategy as information cue (Miles & Snow, 1978) as part of the IPO
documentation.
Miles and Snow Strategy Typology
Having established the importance of corporate strategy as a market
signal, this article now considers types of strategy. In this study, the
Miles and Snow strategy typology is used to classify the corporate
strategy communicated during an IPO event. Compared with other
typologies (Ansoff, 1965; Mintzberg, 1987; Porter, 1980), the Miles and
Snow typology focuses more on the strategic intentions of the firm
rather than actual strategic performance. This typology is particularly
useful at predicting the likely future strategic behaviors and
performance of the firm (Doty et al., 1993; Segev, 1989; Shortell &
Zajac, 1990) and so is appropriate for IPO firms. The Miles and Snow
strategy typology also enables an integrated and systematic examination
of the strategic patterns of the firm (McDaniel & Kolari, 1987;
Zahra, 1987).
The Miles and Snow (1978) typology addresses three problems a firm
might confront: entrepreneurial (product/market) problems, technological
(engineering) problems, and administrative problems. The classification
of firms into one of four strategy types--prospectors, defenders,
analyzers, and reactors--depends on how a firm addresses these three
basic problems.
Prospectors perceive a dynamic, uncertain environment and maintain
flexibility in order to compete in the market (Parnell & Wright,
1993). As such, prospectors usually target broad markets and continually
search for new market opportunities. Prospectors are creators of change
and uncertainty, to which their competitors must respond (Shoham,
Evangelista, & Albaum, 2002). To maintain the advantage of
innovation, prospectors tend to possess a loose structure, low division
of labor, and low formalization and centralization (Parnell &
Wright, 1993).
Defenders perceive a stable and certain environment and thus seek
stability and control in their operations in order to achieve maximum
efficiency (Parnell & Wright, 1993). Defenders have narrow
product/market domains (Miles & Snow, 1978) and defend them
aggressively (Shoham et al., 2002). New product development primarily
relates to existing products and markets (Miles & Snow, 1978).
Because of this narrow focus, defenders improve the efficiency of their
existing operations with a cost-efficient, single-core technology
(Shoham et al., 2002). Defenders adopt an extensive division of labor,
high formalization, and high centralization (Parnell & Wright,
1993).
Analyzers simultaneously highlight stability and flexibility and
attempt to take advantage of both the prospector and defender strategy
types (Parnell & Wright, 1993). Analyzers operate in two types of
product/market domains, one relatively stable and the other changing
(Miles & Snow, 1978). They seek efficiency in stable areas with
formalized structures and processes. At the same time, analyzers monitor
their competitors closely for new ideas in more turbulent areas,
preferring to imitate them rapidly. Analyzers characteristically exert
tight control over existing operations and loose control over new
undertakings. As Parnell and Wright (1993) note, "The strength of
the Analyzer is the ability to respond (imitate) to Prospectors while
maintaining efficiency in operations" (p. 30).
In stark contrast to the other three strategy types is a reactor,
which lacks a consistent strategy-structure relationship and seldom
makes adjustments unless forced to do so due to environmental pressures
(Miles & Snow, 1978). Some researchers describe a reactor strategy
as a residual or unsuccessful strategy type (Hambrick, 1983; Zajac &
Shortell, 1989). This study excludes this strategy type because it is
unlikely that an IPO firm will deliberately pursue or signal an
unsuccessful strategy type.
The Miles and Snow strategy typology provides a functional device
that enables firms to be differentiated from one another according to
their product/ market choices, distinctive adaptive processes, and
internal structures. This, in turn, allows the firms to align to the
environment in which they operate (Hambrick, 1983; McDaniel &
Kolari, 1987; Snow & Hrebiniak, 1980; Woodside, Sullivan, &
Trappey, 1999). Table 1 summarizes the characteristics of each strategy
type and subdomains used in this study. This study presents an IPO
prospectus as a market signaling device that provides accurate insights
into the firm's potential (Daily et al., 2003) and reduces
information asymmetry between managers and those buying and selling
stocks in the IPO firm. This article claims that IPO prospectuses, as
part of the IPO market signaling event, provide an opportunity for
analysts and potential investors to capture multiple dimensions of a
company's corporate strategy. Against this backdrop, we suggest the
following research proposition: An IPO prospectus provides a tool to
signal a firm strategy type.
Signal Quality
So far, we have established an IPO event as an opportunity to
signal the IPO firm's corporate strategy to the market. We now
propose three indices that can be used to understand the quality of the
strategy signal, namely, clarity, intensity, and consistency.
Signal clarity. Extant research finds that an effective signal
should be observable and clear (Certo et al., 2001) so that market
participants can easily capture the signal (Eliashberg & Robertson,
1988; Spence, 1973, 1974). This article proposes that IPO prospectuses
allow IPO firms to present a corporate strategy type by stating their
intention to favor one strategy type over another. If the IPO prospectus
clearly states the firm's corporate strategy, the prospectus reader
will quickly grasp and understand the intended corporate strategy (Heil
& Robertson, 1991). Clear understanding of the firm's strategy
will then encourage the investors or analysts to assess other strategic
information, such as the structure of the firm and its adaptive
processes (Baruch, 1992).
Signal intensity. Scholars suggest that frequently communicated
signals are likely to capture the audience's attention (Riley,
1975; Spence, 1974, 2002). The audience will grasp the signals and
subsequently use them to infer the firm's intended strategy type.
Signal consistency. Signal effectiveness also depends on signal
consistency (Riley, 1975), which means that firms need to consistently
communicate multiple signals from different dimensions and show little
contradiction across dimensions. However, past IPO communication
research has not investigated this aspect of signal quality; signals
under investigation are typically simple, unidimensional, and focused
(Certo et al., 2001; Megginson & Weiss, 1991; Neck et al., 2000). A
clear and intense articulation of the firm's strategy type alone
will not enhance strategy credibility; a firm also needs to show
consistent evidence of a fit between strategy dimensions in order to
establish strategy credibility (Miles & Snow, 1978). Therefore, this
article further employs signal consistency across the dimensions of
corporate strategy to examine the overall quality of corporate strategy
signals-something not done in other IPO studies.
Having identified the characteristics of a credible market signal,
how can a firm determine whether it has been successful in signaling
corporate strategy from an IPO event? To date, a small number of studies
apply signaling perspective to understand an IPO event and its
performance (e.g., Carter et al., 1998; Certo et al., 2001; Megginson
& Weiss, 1991; Neck et al., 2000; Rosenstein & Wyatt, 1997).
Most of these studies examine the effect of IPO signals on the 1st day
of initial returns (i.e., underpricing) as an indicator of whether or
not market signaling has reduced information asymmetry between informed
and uninformed investors (Carter et al., 1998; Certo et al., 2001;
Megginson & Weiss, 1991). These studies justify the 1st-day returns
based upon market efficiency theory, which suggests that the market
responds immediately to information.
In this study, we work with both the 1st-day and 30-day market
returns. We propose that the credible communication of corporate
strategy will result in a very small gap between the offer and 1st-day
price and, therefore, very little underpricing. We also propose that the
three components we have identified as indicating a credible market
strategy signal (clarity, intensity, and consistency) will have a
negative impact on underpricing because they work to reduce information
asymmetry between informed and uninformed investors. Accordingly, this
study suggests the following research hypotheses:
Hypothesis 1a: The clarity of the firm's communication of its
corporate strategy relates negatively to IPO underpricing on the 1st day
of the IPO.
Hypothesis 1b: The intensity of the firm's communication of
its corporate strategy relates negatively to IPO underpricing on the 1st
day of the IPO.
Hypothesis 1c: The consistency of the firm's communication of
its corporate strategy relates negatively to IPO underpricing on the 1st
day of the IPO.
As previously mentioned, this study also includes the signaling
effects of corporate strategy communication on returns 30 days after an
IPO event for two reasons. First, opportunistic investors, who are more
attracted by the potential for underpricing, might not be affected by
the corporate strategy communicated in the IPO prospectus. This is
especially the case for biotechnology IPOs where faddish purchasing
behavior, due to overoptimism of the likely "abnormal return"
from IPOs, is frequently present (Finkle & Lamb, 2002; Ritter, 1991,
1998). Second, analysts and investors may need time to read, understand,
and evaluate the corporate strategy communicated in IPO prospectuses
(Baruch, 1992; Bukh et al., 2002), so they will have a better
understanding of the IPO value after a period of time. Therefore, the
effective communication of corporate strategy might reduce 30-day
initial returns by taking a slightly longer term view of underpricing.
This article also investigates 30-day returns after the IPO event. This
backdrop informs the following hypotheses:
Hypothesis 2a: The clarity of the firm's communication of its
corporate strategy relates negatively to 30-day IPO returns.
Hypothesis 2b: The intensity of the firm's communication of
its corporate strategy relates negatively to 30-day IPO returns.
Hypothesis 2c: The consistency of the firm's communication of
its corporate strategy relates negatively to 30-day IPO returns.
[FIGURE 1 OMITTED]
METHOD
This article reports the findings of a single industry study: the
biotechnology industry. The biotechnology industry is characterized by
emerging, diverse, fast-moving, and hard-to-value products (Ranchhod,
Gurau, & Lace, 2002; Weisenfeld-Schenk, 1994). Accordingly, these
characteristics are likely to drive biotechnology IPO firms to employ
signals in order to reduce uncertainty for investors. This research
analyzes the prospectuses of 57 biotechnology IPOs, representing the
entire population of biotechnology IPOs listed on the NASDAQ between
1997 and 2002.
Bhabra and Pettway (2003) find that prospectus information is more
useful for predicting survival/failure compared with subsequent
information. Thus, the vast majority of IPO signal studies rely on
information available from prospectuses (Cohen & Dean, 2001; Daily
et al., 2003; Neck et al., 2000).
The analysis includes two stages. The first stage applies content
analysis, which allows us to test our research proposition that an IPO
prospectus can be used to identify corporate strategy communication
signals. The study applies a three-phase approach to content analysis.
Phase 1 establishes 13 index variables using the Miles and Snow (1978)
typology of strategy and develops operational definitions for these
variables (see Table 1). This phase also includes the construction of a
coding scheme (i.e., coding book, coding category table, and coding
sheet). We provided a separate column in the coding sheet that allowed
recording of a fourth, ambiguous signal class besides D (defender), A
(analyzer), and P (prospector) for the three signal characteristics of
clarity, intensity, and consistency. This coding allows for the three
levels of class variables for each of the three characteristic types to
be explicitly specified and tested for significance in a regression
model. The fourth class, ambiguous, is appropriately confounded with the
intercept, thereby eliminating unwanted linear dependence among the
variables of interest.
Phase 2 includes a pilot study with two independent coders working
on a subsample of IPO prospectuses to test the validity and reliability
of the coding scheme developed in Phase 1. The first author of the
article and an independent coder participated in the pilot coding
process. The independent coder was experienced in the method of content
analysis and familiar with the Miles and Snow strategy typology. The
coders placed "+" on the coding sheet and entered this as
"1" in the database when the coders identified an index
variable from a case; otherwise, they used "-" and entered
"0." Our research used the Perreault and Leigh (1989) index of
reliability to test for intercoder reliability. In the first pretest,
the reliability indices for the coding of two prospectuses were 62% and
73%, respectively. By comparing the coding notes, the disagreements were
mainly attributed to ambiguous descriptions of operational definitions
of index variables. Subsequently, the coding scheme was revised to
improve the clarity of the definitions. A second pretest was then
conducted to confirm the improvement in coder reliability. The
reliability index was increased to 80%, which met recommended norms
(Neuendorf, 2002; Perreault & Leigh, 1989). After establishing an
acceptable reliability index, the coders worked independently (Perreault
& Leigh, 1989).
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