venture capitalist certification in initial public offerings.docx

THE JOURNAL OF FINANCE VOL. XLVI, NO. 3 JULY 1991 Venture Capitalist Certification in Initial Public Offerings WILLIAM L. MEGGINSON and KATHLEEN A. WEISS* ABSTRACT This paper provides support for the certification role of venture capitalists in initial public offerings. Consistent with the certification hypothesis, a comparison of venture capital backed IPOs with a control sample of nonventure capital backed IPOs from 1983 through 1987 matched as closely as possible by industry and offering size indicates that venture capital backing results in significantly lower initial returns and gross spreads. In effect, the presence of venture capitalists in the issuing firms serves to lower the total costs of going public and to maximize the net proceeds to the offering firm. In addition, we document that venture capitalists retain a significant portion of their holdings in the firm after the IPO. THE ABILITY OF THIRD-PARTY specialists to certify the value of securities issued by relatively unknown firms in capital markets that are characterized by asymmetric information between corporate insiders and public investors has attracted much academic interest in recent years. Several authors, including James (1990), Blackwell, Marr, and Spivey (1990), and Barry, Muscarella, Peavy, and Vetsuypens (1991) have developed and tested models based at least in part on the formal certification hypothesis presented in Booth and Smith (1986). A related body of work, represented by DeAngelo (1981), Beatty and Ritter (1986), Titman and Trueman (1986), Johnson and Miller (1988), Carter (1990), Simon (1990), and Carter and Manaster (1990) has examined how investment bankers and auditors help resolve the asymmetric information inherent in the initial public offering (IPO) process. In this paper we examine whether the presence of venture capitalists, as investors in a firm going public, can certify that the offering price of the issue reflects all available and relevant inside information. We hypothesize that venture capitalists can perforin this function; that it will be an economically *The University of Greorgia, Department of Banking and Finance, School of Business Administration, Athens; and The University of Michigan, School of Business Administration, Ann Arbor; respectively. We are grateful to Mike Barclay, David Blackwell, Michael Bradley, Susan Chaplinsky, Harry DeAngelo, Cliff Holderness (discussant), E. Han Kim, Laura Kodres, Ron Masulis, Jeff Netter, Annette Poulsen, Bill Sahlman, H. Nejat Seyhun, Dennis Sheehan, and seminar participants at Harvard University, the University of Oregon, and Purdue University for their comments and recommendations. We also acknowledge the data collection assistance provided by Rick Mull, Eric Van Houwelingen, and So Han Lee. Financial support for this project was provided by the Center for Entrepreneurial Studies at New York University, the University of Michigan Summer Research Program, and the University of Greorgia Research Foundation. 879 880 The Journal of Finance valuable function; and that the certification provided by venture capitalists will be both a partial subsititute for and a complement to the certification provided by prestigious auditors and investment bankers. We employ a matched pairs methodology where a sample of venture capital (VC) backed IPOs is matched by industry and offering size with a qualitatively equivalent set of non-VC backed IPOs, to focus as clearly as possible on the question of whether venture capital certification occurs and is valuable. Our results strongly indicate that the presence of venture capitalists in offering firms maximizes the fraction of the proceeds of the IPO, net of underpricing and direct costs, which accrues to the issuing firm. Specifically, we document that VC backing reduces the mean and median degree of IPO underpricing and that such backing significantly reduces the underwriting spread charged by the investment banker handling the issue. Further support for the venture capitalist certification hypothesis is provided by our finding that VC backed issuers are able to attract more prestigious auditors and underwriters than non-VC backed issuers. In addition, VC backed issuers also elicit greater interest from institutional investors during the IPO and are able to go public at a younger age than other firms. Finally, the credibility of venture capitalists information is enhanced by the fact that they are major shareholders prior to the IPO and retain significant portions of their holdings after the offer. This study is organized as follows. In Section I, a general model of venture capital certification is provided. The sample selection criteria and descriptive statistics are presented in Section II. In Section III, the comparison of underwriter and auditor quality and the level of institutional shareholdings between VC and non-VC backed firms is examined. Empirical tests of the certification hypothesis are presented in Section IV. The pre- and post-IPO ownership structure of venture capitalists in the issuing firm is documented in Section V. Section VI concludes the study. I. Certification by Venture Capitalists Third party certification has value whenever securities are being issued in capital markets where insiders of the issuing firm and outside investors have different information sets concerning the value of the offering firm. Corporate insiders have an incentive to conceal (or at least delay the revelation of) adverse information because doing so will allow them to sell securities at a higher price. Rational outside investors understand these incentives and will only offer a low average price for the securities offered unless they can be credibly assured that the offering price already reflects all relevant private information. This informationally induced standoff can lead to market failure of the type described by Akerlof (1970) unless the information asymmetry can be reduced. Although Allen and Faulhaber (1989), Grinblatt and Huang (1989), and Welch (1989), have presented signalling models which predict that corporate insiders can unilaterally convey their private information, there are several Venture Capitalist Certification in Initial Public Offerings 881 factors which make first-party statements and actions suspect. For one thing, Gale and Stiglitz (1989) show that IPO signalling models break down when insiders are allowed to sell equity more than once. More fundamentally, insiders have everything to gain and very little to lose from signalling falsely at the time of an IPO. They sell securities only infrequently and thus would only be “punished” far in the future if at all. Their gain, however, would be immediate and possibly quite large. While disclosure regulation will surely discourage flagrant lying and material omissions see Tinic (1988), it is unlikely to be completely effective in forcing disclosure of all relevant information. Therefore, in the absence of effective signalling mechanisms in IPOs, outside investors are likely to be convinced that accurate information disclosure has occurred only if a third party, with reputational capital at stake, has asserted such and will be adversely and materially affected if that assertion proves false. Specifically, for third-party certification to be believable for outside investors, three tests must be met. First, the certifying agent must have reputational capital at stake which would be forfeited by certifying as fairly priced an issue which was actually over-valued. Second，the value of the agents reputational capital must be greater than the largest possible one-time wealth transfer or side payment which could be obtained by certifying falsely. Third, it must be costly for the issuing firm to purchase the services of (lease the reputational capital of) the certifying agent, and this cost must be an increasing function of the scope and potential importance of the information asymmetry regarding intrinsic firm value. There are strong a priori reasons to believe that all three of these tests are met by venture capitalists and that the certification they can provide will have value in an IPO. First, as the Venture Capital Journal (VCJ) (1988) makes clear, many of the more established venture capitalists bring companies in their portfolio to market on an ongoing basis as well as participating, over time, in a stream of direct equity investments in entrepreneurial firms. In our sample, 53 venture capitalists bring more than five firms public from 1983 to 1987. Venture capitalists, therefore, have a very strong incentive to establish a trustworthy reputation in order to retain access to the IPO market on favorable terms. Furthermore, the greater a venture capital funds perceived access to the IPO market the more attractive it will be to entrepreneurs, thus assuring a continuing deal flow. Finally, a reputation for competence and honesty will allow venture capitalists to establish enduring relationships with pension fund managers and other institutional investors who are vitally important as investors in venture capital funds and as purchasers of shares in IPOs. Support for the second criterion, that the value of venture capitalists reputational capital must exceed the maximum possible benefit from certifying falsely, is provided by Sahlman (1990). He documents that (1) successful venture capitalists are able to achieve very high returns on relatively modest capital outlays; (2) these returns are directly related to the age and historical performance of the VC fund, as well as to the size of its investment portfolio; 882 The Journal of Finance (3) successful VC fund managers are able to establish profitable “follow-on” funds and are also able to achieve an enhanced deal flow from entrepreneurs; and (4) the VC fund manager market is a relatively small, tight-knit, and efficient labor market where individual performance is constantly monitored and valued. Therefore, the investment in reputational capital by venture capitalists allows them to remain competitive in the venture capital industry as well as the capital markets. In addition to venture capitalists investment in reputational capital, they also are large shareholders in the issuing firm. One way in which they might profit from false certification and take advantage of the high price is to sell shares in the IPO. Retention by venture capitalists of their holdings after the offer, therefore, can act as a bonding mechanism for credible certification. The final criterion for third-parity certification to be successful or economically valuable is that the services of the certifying agent must be costly for the issuing firm to obtain and the cost structure must be such that a separating equilibrium is achieved between high and low information quality firms. Venture capitalists certainly appear to meet this test since the bundle of services they provideincluding financial capital, managerial and technical expertise, enhanced access to other financial specialists as well as certification when the firm ultimately goes publicis both very costly and very difficult to obtain. For example, Morris (1987), Gartner (1988), and Sahlman (1990) all demonstrate that venture capitalists expect to earn a compound annual return of from 25 to over 50 percent (depending upon the stage of the investment) on their investments in private companies. Therefore, entrepreneurs typically hand over large holdings of equity in exchange for relatively small cash infusions. Nor is this the only cost of VC investment for entrepreneurs. In addition to very high required rates of retxirn, venture capitalists invariably structure their investments in such a way that most of the business and financial risk is shifted to the entrepreneur. As described in Golder (1987), Testa (1987), and Sahlman (1988, 1990), venture capitalists employ rather draconian features in their capital investments, including (1) the use of staged investment under which the venture capitalist retains the right to cancel (cease funding) an entrepreneurs venture; (2) the use of convertible preferred stock as an investment vehicle, which gives the venture capitalist both a clainol senior to that of the entrepreneur and an enforceable nexus of security covenants;1 and (3) the retention by the venture capitalist of the option to replace the entrepreneur as manager unless key investment objectives are met. The cost and stringency of VC investment, as well as the sheer difficulty in obtaining it (venture capitalists typically fund less than one percent of all the proposals they receive), implies that only those firms which would benefit most froir the services venture capitalists provide will be willing and able to accept such participation. While the role of venture capitalists in the firm is 1Megginson and Mull (1991) find that 41.9% of the VC backed firms have convertible preferred stock in their capital structure compared to 12.6% of non-VC backed firms. Venture Capitalist Certification in Initial Public Offerings 883 obviously not limited to their activity at the IPO, one of the services that entrepreneurial firms purchase with VC funding is easier access to capital markets and the ability of venture capitalists to reduce asymmetrical information in the offering process. Logic suggests that growth options which are characterized by both greater information asymmetry and uncertainty are more likely to be associated with new entrepreneurial firms than with older, more established companies. Therefore, the certification function of venture capitalists should be most attractive to relatively young, rapidly growing, research and development-intensive companies. This being the case, we expect such firms to make greater use of VC than do other firms.2 The model of VC certification in IPOs developed above yields three testable hypotheses. First, since the ongoing nature of venture capitalists involved with firms going public builds relationships with all participants in the offering process, VC backed IPOs should have higher quality underwriters and auditors as well as a larger institutional following than comparable non-VC backed firms. Second, the ability of venture capitalists to reduce the information asymmetry associated with a firm involved in the offering process should result in a reduction of both the underpricing associated with the issue as well as the costs of underwriter, legal, auditor, and other miscellaneous expenses. If venture capitalists are able to convey credible information about the firm, the compensation to investors, underwriters, and auditors will be reduced since their cost of acquiring information about the company (personally certifying the issue) will be lowered. Finally, an additional bonding mechanism that ensures that venture capitalists* certification is credible is the level of their capital investment in the firm both before and after the of