Academic journal article Entrepreneurship: Theory and Practice

Founders, Private Equity Investors, and Underpricing in Entrepreneurial IPOs

Academic journal article Entrepreneurship: Theory and Practice

Founders, Private Equity Investors, and Underpricing in Entrepreneurial IPOs

Article excerpt

One 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. …

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