Management Quality, Venture Capital Backing, and Initial Public Offerings

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1 Management Quality, Venture Capital Backing, and Initial Public Offerings Thomas J. Chemmanur * Karen Simonyan ** and Hassan Tehranian *** Current version: August 2011 * Professor of Finance, Carroll School of Management, Boston College, 440 Fulton Hall, Chestnut Hill, MA Phone: (617) Fax: (617) ** Associate Professor of Finance, Sawyer Business School, Suffolk University, 8 Ashburton Place, Boston, MA Phone: (617) Fax: (617) *** Griffith Millennium Chair Professor of Finance, Carroll School of Management, Boston College, 324C Fulton Hall, Chestnut Hill, MA Phone: (617) Fax: (617)

2 Management Quality, Venture Capital Backing, and Initial Public Offerings Abstract In this paper we make use of hand-collected data on the quality and reputation of the management teams of a large sample of 3,240 entrepreneurial firms going public during to conduct the first large-sample study of the relationship between venture capital (VC) backing and management quality and the effect of these two variables on a firm s IPO characteristics and valuation, post-ipo financial and investment policies, and post-ipo operating performance. We hypothesize that VC backing positively affects the quality of a firm s management team, and that both management quality and VC backing play a certifying role in conveying a firm s intrinsic value to the IPO market, reducing the information asymmetry faced by it. Our empirical findings are broadly consistent with the above hypotheses, and can be summarized as follows. First, VC-backed firms are associated with higher management quality compared to non-vc-backed firms. Second, both management quality and VC backing have a positive effect on a firm s IPO underwriter reputation, offer size, post-ipo analyst coverage, and post-ipo institutional equity holdings; and a negative effect on its cost of going public. Third, management quality and VC backing also have a positive effect on firm valuation, both in the IPO and in the immediate secondary market. Fourth, management quality is associated with lower post-ipo leverage ratios, and both management quality and VC backing are associated with larger post-ipo investment levels, and larger values of post-ipo acquisitions. Finally, both VC backing and management quality are positively related to changes in a firm s post-ipo operating performance. While VC backing and management quality act as substitutes in their effect on a firm s IPO characteristics, they act as complements in their effect on a firm s IPO valuation, post-ipo financial and investment policies, and post-ipo operating performance.

3 Management Quality, Venture Capital Backing, and Initial Public Offerings 1. Introduction The role of venture capitalists in adding value to entrepreneurial firms (over and above their role in providing financing) has been widely discussed in the theoretical as well as practitioner literature (see, e.g., Chemmanur and Chen (2006) or Repullo and Suarez (2004)). Practitioners have argued that one specific way in which venture capitalists add extra-financial value to the firms they back is by helping to build up their management teams: see, e.g., Gorman and Sahlman (1989), Bygrave and Timmons (1992). However, there has been little empirical evidence analyzing the relationship between backing by venture capitalists and the quality and reputation of entrepreneurial firm management: the only exception is the pioneering work of Hellmann and Puri (2002) who make use of a sample of 170 high-technology firms in Silicon Valley to study the role of venture capitalists in the professionalization of start-up firms. The first objective of this paper is to extend this literature on the relationship between venture capital (VC) backing and management quality by making use of hand-collected data on the management quality and reputation of a large sample of 3,240 entrepreneurial firms going public during The second objective of this paper is to analyze how VC backing and management quality interact to affect a firm s dealings with the financial market. The quality and reputation of a firm s management can have a certifying effect on firm value. In other words, higher quality and more reputable managers may be able to convey the intrinsic value of their firm more credibly to outsiders, thus reducing the information asymmetry facing their firm in the equity market. This, in turn, implies that a firm s management quality will affect various aspects of its interaction with the IPO market. 1 For example, 1 This certification effect can arise as follows. Senior members of a firm s management team build up reputational capital over their career. These senior managers are involved in repeated dealings with the financial market as part of their job (e.g., raising bank financing or arranging private placements of equity). Further, these managers know that there is a significant chance that they will leave their firm to join another (in other words, they have to interact with the labor market repeatedly) and that their future employer will be influenced by their reputation in dealing with the financial market in deciding whether or not to hire them, as well as in deciding their compensation package. Overpricing or hyping their firm s stock (or deceiving the financial market in other ways) may tarnish their personal reputation in the equity market, thereby diminishing their future value in the labor market. Thus, the greater the personal reputation managers have at stake, the greater is the future loss from mispricing their firm s equity. 1

4 given the importance of managerial quality and reputation in certifying firm value, it is possible that underwriters and other financial intermediaries use this variable, in addition to other measures of firm quality, when choosing firms to take public. Management quality may be a particularly important variable when analyzing younger, smaller, and more obscure firms, which are likely to suffer from a considerable degree of information asymmetry in the equity market. Thus, firms with higher management quality may be associated with more reputable underwriters. Further, given the reduction in information asymmetry resulting from managerial certification, underwriters and other intermediaries may incur lower costs in acquiring and transmitting information about firms with higher management quality and reputation. This, in turn, implies that such firms need to provide underwriters and other intermediaries only a smaller amount of compensation for taking them public, reducing their costs of going public. The reduction in outsiders information acquisition costs for firms with higher management quality could also lead to greater analyst coverage and institutional interest in the IPOs of such firms. Further, if management quality and reputation can certify a firm s intrinsic value to the financial market, firms with higher quality managements may also be able to access the IPO market at a younger age and obtain higher market valuations, both in the IPO market and in the immediate after-market. Higher quality managers may also be able to select better projects (characterized by a larger net present value (NPV) for any given scale) for their firm (see Figure 1 in section 3.3). This, in turn, implies that firms with higher management quality are likely to have a larger equilibrium scale of investment, and therefore larger IPO offer sizes (ceteris paribus). We discuss the underlying theory in more detail and develop hypotheses for our empirical tests in section 3. Similar to the role of management quality that we discussed above, the existing literature has argued that VC backing can also play a role in conveying the intrinsic value of a firm to the financial market (see, e.g., Megginson and Weiss (1991)). If this is the case, then, following an argument similar to the one we made above regarding management quality, VC-backed firms will be associated with higher Therefore, managers of higher quality and reputation are more likely to price their firm s equity more fairly. For a theoretical model of how long-lived players associated with a firm s IPO can help to reduce the information asymmetry facing it in the equity market (and increase its IPO offer price), see Chemmanur and Fulghieri (1994). 2

5 reputation underwriters, lower costs of going public, larger IPO offer sizes, greater analyst coverage and institutional investor holdings, younger age at IPO, and higher IPO valuations. In the only prior paper studying the relationship between management quality and IPO characteristics, Chemmanur and Paeglis (2005) provide support for some of the above relationships that we hypothesized regarding management quality and IPO characteristics. They, however, explicitly exclude VC-backed IPOs in their analysis. Similarly, there has also been prior literature providing some support for the above conjectures on the relationship between VC backing and various aspects of a firm s IPO (see, e.g., Megginson and Weiss (1991) and Chemmanur and Loutskina (2006)). However, there has been no analysis in the existing literature regarding the relationship between management quality and IPO characteristics in VC-backed IPOs, and no analysis regarding how management quality and VC backing interact to affect various aspects of a firm s IPO. Thus, there has been no literature analyzing whether management quality and VC backing are complements or substitutes in their effect on various aspects of a firm s IPO. Our objective in the second part of this paper is to remedy this gap in the literature. Our third objective in this paper is to study how management quality and VC backing affect a firm s financial and investment policies in the years immediately after its IPO. Earlier, we argued that management quality may play an important role in conveying a firm s intrinsic value to the financial market, thereby reducing the extent of information asymmetry it faces. Reduced information asymmetry, in turn, may influence various aspects of a firm s financial policies (see, e.g., Myers and Majluf (1984)). In particular, this implies that firms with better and more reputable managements may be more likely to issue equity (since they are more likely to get a fair price for their stock), so that they will have lower levels of leverage. Further, as we argued earlier, higher quality managers may also be able to select better projects for their firm, characterized by a larger NPV for any given scale. This means that higher management quality firms are likely to have a larger equilibrium scale of investment. The quality of a firm s management may also affect the number and value of its acquisitions. The direction of this effect will depend on which of the following two effects dominates: on the one hand, better and more reputable managers may be more capable of making use of potential synergies arising from the firms they acquire, 3

6 and therefore more likely to engage in acquisitions; on the other hand, if higher quality managers are able to attract and select better new projects, such managers may be less likely to make acquisitions, since they may be able to generate growth through internal sources. If, similar to management quality, VC backing can also serve to convey a firm s intrinsic value to the financial market, we would expect VC-backed firms to have lower leverage (by an argument similar to the one we made above regarding the relationship between management quality and leverage). Further, if the venture capitalists backing a firm can help its managers to select better projects (larger NPV for any given scale), we would expect VC-backed firms to have a larger equilibrium scale of investment. Finally, following an argument similar to the one we made above regarding the relationship between a firm s management quality and its post-ipo acquisitions, we would also expect VC backing to affect the number and value of a firm s acquisitions, though we are a priori agnostic regarding the direction of this effect. There has been no analysis in the existing literature so far regarding the relationship between the management quality of a firm and its post-ipo financial and investment policies; neither has there been any analysis on the relationship between VC backing and a firm s post-ipo financial and investment policies. 2 Our objective in the third part of this paper is to remedy this gap in the literature: we not only analyze the above two relationships, but also study how management quality and VC backing interact to affect a firm s financial and investment policies. The fourth and final objective of this paper is to study how management quality and VC backing affect a firm s post-ipo operating performance. The relationship between a firm s management quality and the level of its post-ipo operating performance may depend on two opposing effects. On the one hand, higher quality managers may be better at selecting more valuable projects and implementing them more ably, generating greater profits on average. On the other hand, as discussed earlier, higher management quality firms may be able to access the financial market at an earlier (younger) stage in their 2 As we discuss in section 2, even in the broader (non-ipo literature) there have been very few analyses studying the relationship between a firm s management quality and its financial and investment policies. Chemmanur, Paeglis, and Simonyan (2009) study the above relationship for a sample of firms making seasoned equity offerings. Bertrand and Schoar (2003) find that manager fixed effects explain some of the heterogeneity in investment, financial, and organizational practices of a sample of seasoned firms. 4

7 life cycle, at which point their profitability is likely to be lower than that of firms going public at a later (older) stage. If the former effect dominates, we would expect management quality to be positively related to the level of post-ipo operating performance; if, however, the latter effect dominates, we would expect management quality to be negatively related to the level of post-ipo operating performance. One can separate out the effect of managerial ability alone on operating performance by studying the changes in operating performance after IPO: we expect firms with better management quality and reputation to experience larger improvements in operating performance in the years immediately after IPO. We argued earlier that venture capitalists may be able to help a firm s management perform better in the product market and also access the financial market at an earlier (younger) stage in their life cycle. If this is the case, then, by an argument similar to the one we made above regarding the relationship between management quality and post-ipo operating performance, we would expect the relationship between VC backing and the level of post-ipo operating performance to be either positive or negative, respectively, depending on whether the effect of management ability dominates or the effect of firm age at IPO dominates. On the other hand, if we study the changes in operating performance post-ipo, we would expect VC-backed firms to experience unambiguously larger improvements in operating performance compared to non-vc-backed firms. There has been no literature on the relationship between the management quality and post-ipo operating performance of VC-backed firms. 3 The literature on the relationship between VC backing and the post-ipo operating performance of firms is also sparse. 4 Our objective in the fourth part of this paper is to remedy this gap in the literature: we not only analyze the above two relationships, but also study how management quality and VC backing interact to affect a firm s post-ipo operating performance. We empirically test the hypotheses discussed above using hand-collected data on the management quality of a large sample of IPO firms that went public during Making use of this data, we 3 Chemmanur and Paeglis (2005) develop a brief analysis of the relationship between the management quality and post-ipo operating performance of non-vc-backed firms. 4 An exception is Jain and Kini (1995), who analyze a sample of firms that went public during and show that VC-backed IPO firms experience relatively smaller declines in post-issue operating performance (relative to the pre-issue year) compared to non-vc-backed firms. 5

8 create ten individual proxies of management quality and reputation (we discus these in detail in section 5.1). Since true management quality itself is unobservable, each of the above ten proxies may have their own unique limitations in capturing this unobservable construct. We therefore conduct a common factor analysis using these individual proxies to produce a single measure of management quality that captures the variation common to these ten observable individual proxies of management quality. We use this management quality factor in most of our subsequent empirical tests (we report some results with our individual proxies of management quality as well). Our empirical findings are as follows. In the first part of our paper, we find that VC-backed firms have larger management teams, greater percentages of management team members with MBA degrees, with prior managerial experience, and with core functional expertise (in operations and production, sales and marketing, research and development, and finance) compared to non-vc-backed firms. At the same time, VC-backed firms have lower percentages of management team members with CPA certifications and with prior managerial experience at law and accounting firms; and their managers have shorter average tenures and smaller heterogeneity in these tenures. Overall, we find that VC-backed firms have a higher management quality than non-vc-backed firms as measured by our management quality factor. In the second part of our paper we find the following. First, both management quality and VC backing have a significantly positive effect on the underwriter reputation of IPO firms, IPO offer sizes, and a significantly negative effect on firms costs of going public. We also find that management quality and VC backing act as substitutes in their effect on the above IPO characteristics: i.e., the effect of management quality on the above IPO characteristics is weaker in VC-backed than in non-vc-backed firms. Second, we find that both management quality and VC backing have a significantly positive effect on the analyst coverage and institutional holdings of firms immediately after their IPO, and act as substitutes in their effect on these variables. Third, we find that firms with higher management quality and those backed by VCs are able to access the financial market at a younger stage in their life cycle. We also find that management quality and VC backing act as complements in reducing firm age at IPO: i.e., the effect of management quality on firm age at IPO is stronger for VC-backed compared to that for non-vc- 6

9 backed firms. This younger age at IPO may be due to the greater participation by various financial market players in the IPOs of higher management quality and VC-backed firms that we documented earlier. Fourth, we find that both management quality and VC backing have a significantly positive effect on IPO firm valuations both in the IPO market and in the immediate secondary market; management quality and VC backing act as complements in their effect on IPO and secondary market valuations. Our findings in the third part of the paper are the following. First, management quality has a significantly negative effect on the post-ipo leverage ratios of firms going public. This effect of management quality on firm leverage is stronger in VC-backed compared to that in non-vc-backed firms. However, we do not find any direct effect of VC backing on firm leverage, either in high or in low management quality firms. Second, both management quality and VC backing have a significantly positive effect on the post-ipo investment levels (capital expenditures and research and development (R&D) expenses) of firms going public, and they act as complements in their effect on investment levels. Third, both management quality and VC backing have a significantly positive effect on the value of acquisitions implemented by IPO firms after they go public. The effect of management quality on the value of a firm s acquisitions is similar in VC-backed and non-vc-backed firms. Our findings in the fourth and final part of our paper are the following. First, both management quality and VC backing have a significantly negative effect on the level of post-ipo operating performance of firms going public. This may be partly due to the fact that firms with higher management quality and those backed by VCs go public and access the financial market at a younger age and thus initially lag behind firms going public at a later stage in their life cycle. The fact that firms with higher management quality and those backed by VCs invest significantly more in the years immediately after their IPO may also contribute to their lower levels of post-ipo operating performance. 5 Second, both VC backing and management quality have a significantly positive impact on the changes in operating 5 Higher levels of capital expenditures and R&D expenses result in smaller accounting earnings and, consequently, in lower accounting performance ratios, such as ROA. For example, higher capital expenditures reduce firm s accounting earnings through higher depreciation charges which are subtracted against revenues in subsequent years; higher R&D expenses reduce earnings as well since they are expensed against revenues in the year they are incurred. 7

10 performance of firms relative to the year prior to their IPO. Thus, we find that VC-backed firms experience significant improvements in their post-ipo operating performance (relative to the year prior to their IPO), while non-vc-backed firms experience a deterioration in their post-ipo operating performance (relative to the year prior to their IPO). Similarly, within VC-backed firms, firms with higher management quality experience significantly larger improvements in post-ipo operating performance compared to firms with lower management quality. Finally, we find that, within the sample of non-vcbacked firms, firms with higher management quality experience a smaller extent of deterioration in post- IPO operating performance compared to lower management quality firms. The above results indicate that firms with higher management quality are indeed able to select better projects and implement them more ably, and that VC backing plays an important role in improving firm performance as well. This paper contributes to the literature in several ways. First, we extend the literature on the effect of VC backing on the management quality of firms pioneered by Hellmann and Puri (2002) by conducting the first large-sample study of this relationship. We are able to show that the positive effect of VC backing on management quality applies to the entire population of firms going public and persists at the time of IPO, unlike Hellmann and Puri (2002), who focus only on this relationship in young hightechnology firms in Silicon Valley. Second, ours is the first paper to study the relationship between management quality and IPO characteristics in VC-backed firms (the only analysis of this relationship, Chemmanur and Paeglis (2005), focuses solely on non-vc-backed firms). By focusing on VC-backed as well as non-vc-backed firms, we are able to analyze not only the effect of VC backing and management quality on IPO characteristics such as underwriter reputation, offer size, cost of going public, firm age at IPO, post-ipo institutional investor holdings and analyst coverage, but also able to study the interaction between management quality and VC backing in affecting these IPO characteristics. Third, this is the first paper to analyze the effect of management quality on the valuation of firms going public (both at IPO and in the secondary market) and the interaction between management quality and VC backing in affecting this relationship. Fourth, this is the first paper in the literature to study the effect of VC backing on the post-ipo financial and investment policies of firms going public, as well as the first paper to study the 8

11 effect of management quality (and the effect of the interaction between VC backing and management quality) on the above financial and investment policies. Finally, this is the first paper to study the effect of management quality on the post-ipo operating performance of VC-backed firms; it is also the first paper to study how management quality and VC backing interact to affect the above performance. The rest of this paper is organized as follows. Section 2 discusses the related literature. Section 3 summarizes the relevant theory and develops our testable hypotheses. Section 4 describes our data. Section 5 develops our measure of management quality and reputation as well as other measures of firm quality and internal governance. Section 6 presents our empirical tests and results. Section 7 concludes. 2. Relation to the Existing Literature Our paper is related to several strands in the empirical and theoretical literature. The first literature is the emerging literature on management quality and its effect on firm performance and a firm s interaction with the financial market. As discussed in the previous section, one paper in this literature is Chemmanur and Paeglis (2005), who study the relationship between various measures of management quality and IPO characteristics in the context of non-vc-backed IPOs. In a seminal paper, Bertrand and Schoar (2003) study a sample of seasoned firms and find that manager fixed effects explain some of the heterogeneity in investment, financial, and organizational practices of these firms. They attribute these fixed effects to the differences in style across managers and link them to observable managerial characteristics, such as age and the institution from which they obtained an MBA degree. 6 However, by focusing on specific managers, they capture the effect of the management styles of various managers on firms investment and financial policies, rather than the relationship between management quality per se and investment and financial policies, which is the topic we study here. 7 6 In particular, they find that CEOs with MBA degrees, as well as younger generations of CEOs, on average, are more aggressive: they have higher levels of leverage, capital expenditures, and lower dividend payout ratios. 7 See also Chemmanur, Paeglis, and Simonyan (2009), who study the effect of management quality on the financial policies of firms making SEOs. Chevalier and Ellison (1999) study how the characteristics of mutual fund managers (age, experience, education, and SAT test scores) affect the performance of their funds. They find that managers who attended higher-sat undergraduate institutions had significantly higher risk-adjusted excess returns. 9

12 The second literature our paper is related to is the literature on venture capital. As discussed in the previous section, Hellmann and Puri (2002) study 170 young high-technology firms in Silicon Valley and show that VC backing is positively related to the professionalization of firm management, as measured by human resource policies, the adoption of stock option plans, and the hiring of a marketing vice president. Kaplan, Sensoy, and Stromberg (2009) use a sample of 50 VC-backed firms to study the evolution in firm characteristics from business plan to public firm, and show that business lines remain remarkably stable while management turnover is substantial. Our paper is also related to the recent empirical literature documenting that VCs help to improve the efficiency of the private firms they invest in: see, e.g., Chemmanur, Krishnan, and Nandy (2011). A number of papers examine the relationship between VC backing and IPO underpricing: see, e.g., Megginson and Weiss (1991) or Lee and Wahal (2004). None of the latter papers, however, touch upon the relationship between VC backing and management quality or the effect of management quality on a firm s IPO characteristics. Finally, our paper is related to the broader literature on IPOs and the role of financial intermediaries such as investment banks and VCs on a firm s interaction with the financial market. Chemmanur and Fulghieri (1994) develop a theoretical model analyzing how long-lived players, such as underwriters, associated with a firm s IPO can reduce the information asymmetry facing the firm in the financial market. In the context of our paper, VCs and high quality and reputation management teams can be viewed as long-lived players helping to reduce the information asymmetry faced by the firm in the financial market. The broader theoretical literature on the pricing of IPOs under asymmetric information is also related to this paper (e.g., Allen and Faulhaber (1989), Chemmanur (1993), or Welch (1989)). 3. Theory and Hypotheses Development 3.1. VC Backing and Management Quality A number of papers have argued that venture capitalists may be able to create extra-financial value for the entrepreneurial firms they invest in (see, e.g., Chemmanur and Chen (2006) or Repullo and Suarez (2004)). Clearly, one way in which they can create such value is by helping the entrepreneurial 10

13 firm acquire a higher quality management team either by attracting more qualified managers to join the firm or by fostering the development of a higher quality management team in other ways: see, e.g., Gorman and Sahlman (1989) and Bygrave and Timmons (1992) for informal arguments that venture capitalists help to professionalize firm management, and Hellmann and Puri (2002) for some empirical evidence. Thus, the first hypothesis we test is regarding the relationship between VC backing and the quality of a firm s management team at the time of IPO. We expect VC-backed firms to have management teams with higher quality and reputation compared to non-vc-backed firms (H1) Management Quality, VC Backing, and the IPO Market In this section, we develop hypotheses regarding the relationship between management quality, VC backing, and various variables characterizing a firm s interaction with the IPO market, namely, underwriter reputation, underwriting spread and other costs of going public, IPO offer size, analyst coverage and institutional investor holdings immediately post-ipo, firm age at IPO, and firm valuation at IPO and in the immediate after-market. The VC literature has long argued that, since venture capitalists (like other financial intermediaries) are long-term players in the financial market, VC backing may certify an IPO firm s intrinsic value to the financial market (thus reducing the extent of asymmetric information faced by the firm): see, e.g., Megginson and Weiss (1991) for informal arguments and evidence, and Chemmanur and Fulghieri (1994) for a theoretical model of certification by financial intermediaries. At the same time Chemmanur and Paeglis (2005) have argued that, similar to VCs, higher quality management teams may also be able to certify intrinsic firm value to the financial market, thus reducing the extent of information asymmetry faced by the firm. This is because, since management team members are involved in repeated dealings with the financial market as part of their job, and concerned with preserving their reputation, the financial market will view management teams of higher quality and reputation as more credible. The above certification ability of VCs as well as higher quality management 8 In developing testable hypotheses, we only number those hypotheses regarding which there has been no evidence presented in the existing literature. 11

14 teams has important implications for the relationship between VC backing, management quality, and various variables characterizing firm s interaction with the IPO market, which we discuss below. An additional interesting question that arises here is how the relationship between management quality and IPO characteristics differs across VC-backed and non-vc-backed firms. In other words, are management quality and VC backing substitutes or complements in affecting a firm s interaction with the IPO market? Management Quality, VC Backing, and Underwriter Reputation Given the importance of management quality and reputation in certifying firm value, it is likely that underwriters and other financial intermediaries use this variable, in addition to other measures of firm quality, when evaluating firms to take public. 9 Chemmanur and Fulghieri (1994) and Carter and Manaster (1990) argue that more reputable underwriters will be associated with higher quality and less risky firms (see also Booth and Smith (1986)). This, in turn, implies that firms with higher management quality and reputation will be associated with more reputable underwriters (H2). 10 In a similar vein, if VCs are able to certify intrinsic firm value, VC-backed firms will be associated with higher reputation underwriters. Further, if management quality and VC backing are complements in their certification ability, we expect the effect of management quality on underwriter reputation to be stronger in VC-backed firms relative to non-vc-backed firms (H3A); the reverse will be true if management quality and VC backing are substitutes in terms of certification (H3B) Management Quality, VC Backing, and the Costs of Going Public Given the reduction in information asymmetry due to managerial certification, underwriters and other intermediaries may need to incur only lower costs in acquiring and transmitting information about firms with higher management quality and reputation. This, in turn, implies that such firms need to 9 This may be a particularly important variable for younger, smaller, and more obscure firms, which are likely to suffer from a considerable degree of information asymmetry in the equity market. 10 There is no evidence so far in the literature analyzing the relationship between management quality and various IPO characteristics such as underwriter reputation, costs of going public, and IPO offer size in VC-backed firms (Chemmanur and Paeglis (2005) study these relationships in non-vc-backed firms). 12

15 provide underwriters and other intermediaries only a lower amount of compensation (underwriting spread and other expenses) for taking them public (H4). In a similar vein, if VCs are able to certify intrinsic firm value, VC-backed firms will be associated with lower costs (underwriting spread and other expenses) of going public. Similar to their effect on underwriter reputation, if management quality and VC backing are complements in their certification ability, we expect the effect of management quality on the costs of going public to be stronger in VC-backed firms relative to non-vc-backed firms (H5A); the reverse will be true if management quality and VC backing are substitutes in terms of certification (H5B) Management Quality, VC Backing, and IPO Offer Size The quality and reputation of a firm s management will also have a significant impact on the amount raised by the firm in the IPO. First, since they are likely to be better at both selecting and implementing projects, higher quality managers will have better quality projects (i.e., larger NPV for any given scale), so that the equilibrium scale (level of investment) of their projects will be larger. Second, managers with higher quality and reputation will be able to convey their private information about project quality to the equity market more credibly (as discussed above), so that the adjusted NPV (net of financing costs) of firms with higher management quality and reputation will be larger for any given scale. These two effects together will lead to a larger amount raised in the IPOs of firms with higher management quality and reputation (H6). In a similar vein, if VC-backed firms have higher quality (scalable) projects compared to non-vc-backed firms, and given that venture capitalists have some certification ability, we would expect VC-backed firms to raise larger amounts in their IPOs compared to non-vc-backed firms. Similar to their effect on the other two IPO characteristics discussed above, if management quality and VC backing are complements in affecting IPO offer size, we expect the relationship between management quality and IPO offer size to be stronger in VC-backed firms compared to non-vc-backed firms (H7A); the above relationship between management quality and IPO offer size will be weaker in VC-backed firms if management quality and VC backing are substitutes (H7B). 13

16 Management Quality, VC Backing, and Other Financial Market Players Similar to the case of IPO underwriters, management quality may also play an important role in certifying the firm s intrinsic value to other important financial market participants such as financial analysts and institutional investors. If this is the case, the cost of information production of these financial market players will be reduced, so that higher management quality firms will be associated with greater analyst coverage and institutional investor participation immediately post-ipo (H8). In a similar vein, if venture capitalists are able to certify intrinsic firm value, VC-backed firms will be associated with greater analyst coverage and institutional investor participation immediately after the IPO. Finally, if management quality and VC backing are complements in their certification ability, we expect the effect of management quality on analyst coverage and institutional investor participation to be stronger in VCbacked firms relative to non-vc-backed firms (H9A); the above relationship between management quality and analyst coverage and institutional investor participation will be weaker in VC-backed firms if management quality and VC backing are substitutes in terms of certification (H9B) Management Quality, VC Backing, and Firm Age at IPO If management quality is able to certify firm value to the financial market, then firms with higher management quality will be able to access the financial market more easily, as proxied by the firm age at IPO (H10). In a similar vein, if venture capitalists are able to certify intrinsic firm value, VC-backed firms will have younger ages at IPO: the empirical literature has documented this to be the case (see, e.g., Megginson and Weiss (1991) or Lee and Wahal (2004)). Finally, we will also study (as in the case of earlier variables) whether management quality and VC backing are complements or substitutes in terms of making it easier for the firm to access the financial market Management Quality, VC Backing, and Financial Market Valuation If management quality is able to certify a firm s intrinsic value to the financial market, firms with higher management quality will be associated with higher valuations in the IPO market and also in the 14

17 immediate after-market (H11). In a similar vein, if venture capitalists are able to certify intrinsic firm value, VC-backed firms will be associated with higher IPO and secondary market valuations. Finally, if management quality and VC backing are complements in their certification ability, we expect the effect of management quality on IPO and secondary market valuations to be stronger in VC-backed firms relative to non-vc-backed firms; the above relationship between management quality and IPO (as well as secondary market) valuations will be weaker in VC-backed firms if management quality and VC backing are substitutes in terms of certification. While we also study the relationship between management quality and IPO underpricing in this paper, we will not test any specific hypotheses regarding this relationship here. This is because underpricing reflects differences in IPO and secondary market valuations. If management quality positively affects secondary market valuations to a greater extent compared to its effect on IPO valuations, then management quality will have a positive effect on IPO underpricing. On the other hand, the relationship between management quality and IPO underpricing will be negative if management quality has a smaller positive effect on secondary market valuations compared to its effect on IPO valuations. Similar arguments apply to the relationship between VC backing and IPO underpricing Management Quality, VC Backing, and the Financial and Investment Policies of a Firm Earlier, we argued that due to the certifying effect of management quality, firms with high management quality are likely to face a reduced extent of information asymmetry in the IPO market. This reduction in information asymmetry may affect a firm s financing policy. As shown by Myers and Majluf (1984), equity is the financing vehicle of last resort when a firm faces information asymmetry in the capital markets (see also Giammarino and Lewis (1989) and Noe (1989)). However, in the presence of other market imperfections (e.g., costs of financial distress associated with debt), a firm may raise a 11 Perhaps because of this, the relationship documented in the literature between VC backing and IPO underpricing is ambiguous: papers analyzing this relationship prior to the 1990s document it as a negative one (e.g., Megginson and Weiss (1991)), while those using data from the 1990s or subsequently document this relationship as a positive one (see, e.g., Chemmanur and Loutskina (2006), Lee and Wahal (2004), Francis and Hasan (2001)). 15

18 significant portion of financing by issuing equity, since it trades off the financing costs arising from information asymmetry with those arising from these other imperfections. In such a setting, the lower the extent of asymmetric information facing a firm, the greater the equilibrium fraction of external financing raised by issuing equity. In summary, this theory predicts that, ceteris paribus, firms with higher quality managements will be associated with lower leverage ratios (H12). In a similar vein, if venture capitalists are able to certify intrinsic firm value and thus reduce the extent of information asymmetry facing the firm, VC-backed firms will be associated with lower leverage ratios (H13). Finally, if management quality and VC backing are complements in their certification ability, we expect the negative relationship between management quality and leverage ratios to be stronger in VC-backed firms relative to non-vcbacked firms; the above relationship between management quality and leverage ratios will be weaker in VC-backed firms if management quality and VC backing are substitutes in terms of certification. We now discuss the effect of management quality on a firm s investment policy. If higher quality and more reputable managers are able to select better projects for their firms (characterized by a larger NPV for any given scale), and assuming decreasing returns to scale, a firm with higher management quality will be associated with a larger equilibrium scale of investment (see Figure 1). A larger scale of investment, will, in turn, be reflected in higher levels of capital expenditures and R&D expenses, so that these will also be increasing in a firm s management quality (H14). Following a similar argument, if venture capitalists motivate firm management to select better projects for their firms (characterized by a larger NPV for any given scale), and assuming decreasing returns to scale, VC-backed firms will also be associated with higher levels of capital expenditures and R&D expenses (H15). Finally, if management quality and VC backing act as complements in affecting project selection and implementation, we expect the positive relationship between management quality and the level of capital expenditures and R&D expenses to be stronger in VC-backed firms relative to non-vc-backed firms; the above relationship will be weaker in VC-backed firms if management quality and VC backing act as substitutes. 16

19 Net Present Value of Last Dollar Invested High (H) Management Quality Increasing Management Quality Low (L) Management Quality I * L I * H Equilibrium Scale Expands with Management Quality Scale of Investment Figure 1: Relationship between Management Quality and Investment. As management quality increases from low (L) to high (H), the scale of the firm increases from I * L to I * H. The quality of a firm s management may also affect the number and value of its acquisitions. On the one hand, if higher quality managers are more capable of making use of the synergies arising from acquisitions, then such managers will be more likely to engage in acquisitions post-ipo. On the other hand, if higher quality managers are better at attracting and selecting valuable projects for their firm, then such managers will be less likely to make acquisitions post-ipo, since they can generate growth internally (reducing the need for acquisitions). The net result of these two opposing effects is a priori ambiguous. Following a similar argument, the effect of VC backing on the number and value of IPO firm acquisitions is a priori ambiguous, since on the one hand VC-backed firms may be more capable of utilizing the possible synergies arising from acquisitions, while on the other hand they may be more capable of generating growth internally (reducing the need for acquisitions). Given this, while we will study these relationships empirically, we will not test any hypotheses regarding the relationship between management quality or VC backing and the number and value of IPO firm acquisitions. 17

20 3.4. Management Quality, VC Backing, and Post-IPO Operating Performance The relationship between management quality and the level of post-ipo operating performance may depend upon two opposing effects. On the one hand, more able managers may be better at selecting and implementing projects, thereby generating greater profits, on average, for their firm. If this effect of managerial ability is the dominant effect, the quality of a firm s management will be positively related to its post-ipo operating performance (H16A). On the other hand, as discussed earlier, higher management quality firms may be able to access the financial market at an earlier (younger) stage in their life cycle, at which point their profitability is likely to be lower than that of firms going public at a later (older) stage. If this stage effect is the dominant effect, the quality of a firm s management will be negatively related to the level of its long-term operating performance subsequent to the IPO (H16B). One can separate out the effect of managerial ability alone on operating performance by studying the changes in operating performance after IPO: we expect firms with better management quality and reputation to experience unambiguously larger improvements in operating performance in the years immediately after IPO (H17). By an argument similar to the above, if venture capitalists can help a firm perform better in the product market and also access the financial market at an earlier (younger) stage, then we would expect the relationship between VC backing and post-ipo operating performance to be either positive or negative, depending on whether the ability effect dominates (H18A) or the stage effect dominates (H18B). Finally, if we study the changes in post-ipo operating performance, we would expect VCbacked firms to experience unambiguously larger improvements in operating performance compared to non-vc-backed firms (H19), if venture capitalists can indeed help firm management pick better projects and implement them more ably. It is also interesting to study whether management quality and VC backing are complements or substitutes in their effect on post-ipo operating performance. 4. Data and Sample Selection We obtained the list of IPOs conducted in the U.S. between 1993 and 2004 from the SDC/Platinum Global New Issues database. Next we eliminated real estate investment trusts (REIT), 18

21 closed-end funds, unit IPOs, spin-offs, equity carve-outs, financial firms (all firms with SIC codes between 6000 and 6999), foreign firms, and former leveraged buy-outs (LBO). We further eliminated 9 firms which did not have management quality information available in their prospectuses. Thus our final sample consists of 3,240 IPO firms, out of which 1,851 are VC-backed firms, and the remaining 1,389 are non-vc-backed firms. Table 1 demonstrates how our final sample was constructed. Information on various management quality proxies, such as team size, education, prior managerial experience, functional expertise, and tenure of management team members was handcollected from the Management section of IPO prospectuses. The data necessary to calculate the CEO dominance variable came from the Executive Compensation section of the prospectuses. Information on internal governance mechanisms (such as CEO/Chairman-of-the-board duality, proportion of outside directors, and insider stock ownership) came from the prospectuses as well. IPO prospectuses were obtained from the Thomson Financial database. IPO characteristics were taken from the SDC/Platinum Global New Issues database. Information on the number and value of post-ipo acquisitions was taken from the SDC/Mergers & Acquisitions database. Information on the institutional shareholdings was obtained by searching 13F and 13F-E filings. The financial analyst coverage data was obtained from IBES. Finally, accounting data came from Compustat and stock price data came from CRSP. 5. Measures of Management Quality and Reputation, and Firm Quality 5.1. Measures of Management Quality and Reputation In this section, we describe our measures of management quality and reputation. We follow Chemmanur and Paeglis (2005) in constructing many of these measures. Management quality is affected by the amount of human and knowledge resources (including education level and prior experience) available to the management team. Thus, our first proxy of management quality, the management team size, measures the amount of human resources available. It is defined as the number of executive officers with a title of a vice president or higher on the management team (TSIZE). The next two proxies of management quality measure the education level of managers. Our second proxy of management quality 19

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