ISSUER S LEGAL COUNSEL IN THE INITIAL PUBLIC OFFERING: IMPACT OF EXPERTISE

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1 ISSUER S LEGAL COUNSEL IN THE INITIAL PUBLIC OFFERING: IMPACT OF EXPERTISE Jørgen Alexander Lisøy Thesis Supervisor: Jens Martin Master thesis Master International Finance University of Amsterdam, Amsterdam Business School September 2014

2 Table of Contents SECTION 1: INTRODUCTION SECTION 2: LITERATURE REVIEW ISSUERS LEGAL COUNSEL IN THE INITIAL PUBLIC OFFERING THE ROLE OF THE LEGAL COUNSEL REGISTRATION STATEMENT LAW FIRM REPUTATION AND SIGNALING EFFECT LEGAL LIABILITY ACQUIRING LEGAL COUNSEL LEGAL EXPENSES HOT AND COLD MARKETS LAW FIRM VALUE CREATION INTRODUCTION LAW FIRM AND UNDERPRICING MARKET TIMING AND WITHDRAWAL LONG TERM GROWTH SECTION 3: HYPOTHESIS AND METHODOLOGY INTRODUCTION HYPOTHESIS 1 HYPOTHESIS 2 HYPOTHESIS 3 HYPOTHESIS 4 SECTION 4: DATA, EMPIRICAL RESULTS, AND DISCUSSION DATA SUMMARY STATISTICS DATA ANALYSIS PRESTIGE AND UNDERPRICING LEGAL FEES IN CRISES LAW FIRM PRESTIGE AND WITHDRAWAL LAW FIRM PRESTIGE AND COMPANY LONG- TERM GROWTH ROBUSTNESS CHECK SECTION 5: CONCLUDING SECTION BIBLIOGRAPHY APPENDIX

3 Section 1: Introduction The initial public offering (IPO) is the first sale of stock by a company to the public. By going public companies gain greater liquidity and better access to capital. When the decision to go public is made the company engages a team of IPO advisors, hereunder a legal counsel. The issuer s legal counsel handles the preparation of the registration statement, and advises the company on compliance with related disclosure requirements. Legal counsel plays an important role in making the required filings with the SEC (Securities and Exchange Commission), responding to SEC comments on the filings and resolving issues that the SEC may have. For the marketing phase of the IPO the legal counsel review the marketing material to ensure that it is consistent with the prospectus (Registration statement). This decreases the probability of ex post litigation and minimizes problems after the company s entrance to the stock market. In the decision on which law firm to hire price is an important factor, there are additional costs for high reputation law firms. Professor Steven L. Schwarz at Duke University finds in a survey that approximately 43% of client respondents would consider hiring a law firm with high reputation simply because the opposing party did so (Schwarcz, 2007). An important question is whether the additional cost charged by a highly reputed law firm result in increased economic value for the issuer? During an initial public offering investors seek signals of quality such as reputational intermediaries, which serve as proxies for that of the issuing company. These signals are important because there is information asymmetry between the parties involved in the IPO transaction and investors following the IPO. Existing literature has examined the prestige of the invest bank (Underwriter) as a signal of quality of the underlying company. Investment banks with higher reputation had a statistically significant negative correlation with underpricing. However, the prestige of law firms representing the issuing company has received limited attention. 2

4 Going public provides new challenges for a company in terms of regulations, corporate governance and increased earnings requirements. CFOs main reason to remain private is to preserve decision- making control and ownership (Brau & Fawcett, 2006). Experienced legal counsel can advise the company on the establishment of its corporate governance structure, policies and procedures so that the company can operate effectively and in compliance with applicable governance laws and regulations after the IPO (Allison, Hall, & McShea, 2008). Will this provide a platform for future success of the company? CFOs reported overall market conditions to be the number one constituent when timing an IPO (Brau & Fawcett, 2006). Timing of the IPO can affect both returns and the success of the IPO. A firm can experience significant losses, both tangible and intangible, due to a withdrawal of the IPO. Will legal counsel with more experience in the IPO process have a better ability to evaluate the chance of a successful IPO? The research topic of this thesis is defined as: Does the expertise of the issuer s legal counsel generate added value in the initial public offering? A master thesis submitted in September 2013 at Amsterdam Business School looked at the impact of law firms on the IPO process (Huang, 2013), including the affect of legal expenses on subsequent lawsuits. This thesis will contribute to academic research by building on existing literature and introducing prospectus size as a proxy for complexity. It will look into the role of issuer s legal counsel in the IPO process, added value of experience and how it decreases informational asymmetry. An important aspect is whether the benefits associated with a higher quality law firm outweigh the cost for the issuer in the IPO process. This includes the probability for a successful IPO, long- term growth and reduction in underpricing. Interview of a major IPO lawyer has provided valuable information to this study (Appendix p.46). The data and theory are concentrated on US law firms and IPOs, but the relationships are predicted to be valid across borders. 3

5 Section 2: Literature review Issuers legal counsel in the initial public offering The role of the legal counsel Issuer s legal counsel has several important roles in the IPO process. In the appendix (page 37) a general timeline and responsibility chart from Practicing Law Institute is included. The chart includes the responsibilities for the issuing company, Company counsel (issuer s legal counsel), selling shareholders, selling shareholders counsel, the underwriter, underwriter s counsel and the auditor. This chart does not include the work responsibilities of the parties prior to the initial organizational meeting. Prior to the meeting issuer s legal counsel assist the company in gathering important information and preparing the business plan for presentation to prospective lead underwriters. Preparations for the initial meeting also include preliminary negotiations on the terms of the offering, including the engagement of lead underwriter(s). Issuer s legal counsel guides the company and its shareholders through the whole IPO process. Together with the CEO and CFO they lead the companies IPO preparations in the areas of executive compensation, creation of stock options, revision of existing employee benefit plans and renegotiation of covenants in loan agreements that restrict the offering. Legal counsel can advise the company on decisions regarding corporate governance structure, policies and procedures. A legal counsel with strong expertise in public company law can greatly benefit the company. (Allison, Hall, & McShea, 2008). Legal counsel of the issuing company handles the preparation of the registration statement, and advises the company on compliance with related disclosure requirements. The disclosures include the management discussion and analysis, uses of proceeds and risk factors. Legal counsel also play a key role when it comes to making the required filings with the SEC, responding to SEC comments and resolving issues that the SEC may have. 4

6 The legal counsel coordinates the company s responses to the due diligence requests of the managing underwriters. The legal counsel also limit the probability for ex- post litigation by educating the company on responsibilities and restrictions that will apply while in registration and following the IPO. For example there are two time windows with publicity restrictions (Quiet periods). The first window extends from the initial filing of the registration statement until the SEC declares the filing effective (approved). During this time the issuer, company insiders, analysts, and other participants are legally restricted to discuss or promote the upcoming IPO. The second quiet period is usually calendar days following an IPO's first day of trading. For the road show the issuer s legal counsel plays an important role by reviewing all the marketing material. For example the investor presentation to see that it is consistent with the prospectus. The legal counsel also files the listing application with the stock exchange, serve as the principal contact to the stock exchange and manages the closing. Responsibilities also include reviewing and negotiating the lockup agreements. This is the commitment from insiders and other large stakeholders not to sell their shares for a period of time after the offering. They also coordinate arrangements with the transfer agent, Depository Trust Company (DTC), the CUSIP Service Bureau and the banknote company. Registration statement The US securities act of 1933 requires the issuers who offer ownership shares to the investing public to register with the SEC. The company cannot sell the securities until the SEC declares the filing effective. The registration statement has two principal parts. The first part refers to the prospectus, which must be accessible to the public. The prospectus must provide information on the company s business operations, financial condition and management. Part two contains additional information that the company is not required to present to investors, but this information can be requested from the SEC by anyone. The filing of the registration statement requires the issuer to provide 5

7 audited financial statements for three fiscal years, prepared according to SEC regulations. In addition to the information required by the form, a company must also provide information that a reasonable investor would need to decide whether to invest in the IPO. Examples of such information are lack of business operating history, adverse economic conditions in a particular industry, lack of a market for the securities offered and the company s dependence upon key personnel. According to the article (Beatty & Welch, 1996) the prospectus has several functions, both formal and informal. Formally the prospectus is designed to provide disclosure of necessary information to potential investors, so they can make an informed investment decision. Informally the prospectus is a promotional document, used for marketing in the selling phase of the IPO. Law firm reputation and signaling effect During an IPO Investors seek signals of quality such as reputational intermediaries, which serve as proxies for the issuing company. In their article (Paczkowski & Quttainah, 2012) find that the prestige of the law firm representing the issuing firm provides a signal of quality of the issuer. In the interview (IPO Lawyer, 2014) it is acknowledged that the reputation of the law firm indirectly provides added value. Reputation is something you deserve and comes from experience and by providing good legal services. An experienced counsel can deliver good quality advice and prospectus. Performance will affect the IPO and that comes from experience. Purely reputation in terms of the name of the law firm will not affect the IPO in particular. But if all of the players in the IPO are unknown the overall picture will be a negative factor in the success of the IPO. The findings of (Schwarcz, 2007) support the interview in the limitations to the signaling effect of law firm reputation: Reputational value per se is less important than the quality and experience provided by high- reputation transactional counsel, who add value primarily by performing better legal work. 6

8 In the article (Schwarcz, 2007) 100% of client respondents and almost 99% of lawyer respondents cited experience as the most important reason that law firms contribute to the success of a transaction. The value of reputation by itself was a secondary. Legal Liability Section 11 of the US securities act of 1933 mandates that accountants, underwriters, issuers, persons signing the registration statement and other experts preparing part of the registration statement are jointly and severally liable for damages as a result of false or misleading information presented in the registration statement. However legal counsel for the issuer is not held to the same standard, except in rare circumstances when the legal counsel is considered to be an expert. For example the legal counsel might be considered as an expert if an expert opinion is offered in the registration statement concerning tax status of the transaction (Beatty & Welch, 1996). A reasonable assumption is that given that competent lawyers themselves are insulated from legal liability, they might allow the issuer to be more aggressive in the prospectus. Acquiring legal counsel Given the legal structure, company counsel is not expected to be subject to a high degree of legal liability, however involvement in bad or fraudulent offerings is likely to be undesirable for any law firm. The interview (IPO Lawyer, 2014) found that the most important consideration for the law firm was to evaluate whether it was realistic to take the company public. If there were doubts in terms of the integrity of the company, serious law firms would not accept the assignment. In the interview it was mentioned that law firms acquire business both proactively and via contact from companies that want to go public. The decision usually goes via a pitch to the issuing company, when a number of law firms are invited to show their credentials and provide an estimate of costs. Important elements in the hiring process are price, experience, contacts and personal chemistry. 7

9 There are to main factors that increase the value of the law firm and make it more competitive in terms of being selected as legal counsel. The first factor is if a law firm is associated with a successful IPO. The second factor is if the law firm is associated with an IPO of a well- known issuer. It is all about credentials, so if your credential includes some of the biggest IPOs it will defiantly affect the competitiveness. This raises the question whether high quality law firms are selective in choosing which issuer to represent. The interview found that working with a high quality issuer lowers the risk profile, for example if the company already has high standards in terms of disclosure and how they treat their shareholders in the market. Also if the company is well organized the information flows are quicker. All this contributes to making the job easier for the legal counsel. Legal expenses In (Beatty & Welch, 1996) they find that offering scale is related to law firm compensation, but not enough to warrant estimating percentage lawyer compensation. There is a strong quality premium for high quality law firms and regressions show that lawyers are paid less when insiders retain more of their earnings. They also find that legal firms are compensated for their reputation, the workload and for the risk involved. In IPOS all participating lawyers must disclose their compensation. In their article (Beatty & Welch, 1996) find that in the early eighties lawyer compensation was almost independent of economic risk and the quality of the lawyer. In the 1980s, lawyer compensation made very little difference as to the compensation of other experts or IPO underpricing. In the 1990s, they found that quality lawyers charged significantly more (size adjusted). In the interview (IPO Lawyer, 2014) timing and complexity were mentioned as the two major drivers of legal fees. Hot and cold Markets Supply and demand theory suggests that a lower a number of IPOs will force IPO legal specialists to decrease their fees to compete for business. Results from empirical tests conducted in the article (Lowry, 2003) indicate that capital demand 8

10 contribute to fluctuations in IPO volume. The basic intuition behind the capital demand hypothesis is that when firms expect higher economic growth, they tend to seek extended financing in order to fund capital investments. The information asymmetry hypothesis mentioned in the article of (PAGANO, FABIO, & LUIGI, 1998) predicts that the firm will only go forward with the IPO if the present value of proceeds exceeds the direct issue costs plus any adverse- selection costs. That means that as information asymmetry in the market increases, firms will have less incentive to perform an IPO. Since information asymmetry is larger for smaller firms with less operational history, the likelihood of an IPO increase with the size of the company. The interview (IPO Lawyer, 2014) found that in terms of legal fees in periods of recession are frequently done on a fixed cost bases. In terms of floating costs there are some counterbalancing effects during crises. Fewer IPOs mean more aggressive pricing, but at the same time you have more complexity. In IPOs the pricing effect is usually stronger, but in rights offerings and seasoned equity offerings (SEO) the complexity effect is higher because they are often critical in the continuance of the company. Law firm value creation Introduction In this study the expression value refers to monetary value. This would include not only lowering direct costs but also indirectly saving costs. The interview conducted (IPO Lawyer, 2014) found that law firms add value to the transaction in three different ways. Firstly by making sure that the prospectus is correct to avoid ex post litigation and minimize problems after the IPO. Secondly experienced legal counsel can assist the company in developing a positioning strategy and legal framework to ensure future success for the company. Lastly by timing the IPO according to market status. From the article (Schwarcz, 2007) transactional lawyers add value by acting as reputational intermediaries. Greater trust is given to information when the party giving that information is represented by a reputable law firm. 9

11 Law firm and underpricing Underpricing occurs when the closing price of the IPO on the first day of trading is higher than the offering price. A large spread between the initial price and the closing price indicates a lost opportunity for profits for the issuing firm and the investment bank (Paczkowski & Quttainah, 2012). While the investment banker is the one agent best suited to price the offering, his information and expertise is inferior to the pooled talents of the market (Rock, 1986). In the United States IPOs are on average underpriced by 18 20%. During the hot issue period underpricing was much higher, as many of the IPO firms did not have strong financials or growth potential (Booth, 2014). The article (Rock, 1986) argues that the risk of the IPO drives underpricing and that uninformed investors must be compensated for participating in the IPO due to winners curse. Winners curse is described as the phenomenon where if IPO goes well, demand exceeds supply (stock underpriced). Stock allocation for each investor is rationed. When an IPO does not go well, supply exceeds demand; uninformed investors receive all the shares they ordered (stock overpriced). The article (Brau & Fawcett, 2006) found that CFOs are well informed regarding expected underpricing. They attribute most underpricing to market uncertainty and the need to reward investors for taking the risk of the IPO. In (Paczkowski & Quttainah, 2012) they find that in the US issuer law firms have marginally significant direct effect on IPO underpricing. However, prestige of the law firm representing the issuing company has a moderating influence on the underpricing of the IPO. In their article (Barondes & Sanger, 2000) examined whether experienced legal counsel are more aggressive in requiring adverse disclosure and whether this would decrease in price realized. Decreased value of the firm could effect underpricing through the partial adjustment phenomenon, examined by (Hanley 1993). They found a significant negative relationship between market share of the law firm representing the underwriter and the offering price. However the relationship between experience of the issuers counsel and price were less clear. This is 10

12 attributed to client relationships potentially being stronger in the case of issuers counsel. From the interview (IPO Lawyer, 2014) it is stated that a better law firm will ensure better quality disclosure. The interview defines better quality disclosure as correct disclosure, not more or less disclosure. Experienced law firms go in depth and ensure that important aspects of the company are described correctly, and are also able to better evaluate what is relevant. Whether better disclosure would translate into higher pricing was unclear, as there is only a small group of investors that read the prospectus. However the prospectus does form the basis for the analyst reports and big investors read the prospectus. So it is a small but sophisticated group that is able to determine whether the disclosure is sufficient. (FERRIS, HAO, & LIAO, 2012) examined prospectus conservatism and found evidence that prospectus conservatism is positively related to underpricing. Market Timing and withdrawal Timing of the IPO is crucial. CFOs reported overall market conditions to be the major constituent when timing an IPO (Brau & Fawcett, 2006). A firm can experience significant losses, both tangible and intangible, due to a withdrawal. In the interview (IPO Lawyer, 2014) the filing time was given as one of the biggest reason for withdrawal of IPO filing. This due to market timing and costs associated with engaging legal and financial counsel over time. The regulator needs to approve the prospectus in time and all the work streams need to complete. Experienced counsel will have experience with the process and will therefore be more qualified to meet deadlines. Less experienced company counsel can be more conservative in what they think is allowed, that can hinder the process. From (Dunbar, 1998) it is suggested that offerings are unsuccessful if either investors do not believe that the issuing firm has good future prospects or the investment bank does an inadequate marketing job. Differences in the timing of IPO pricing should affect the relation between offering characteristics and the probability of success. 11

13 Long term growth Going public provides new challenges for a company in terms of regulations, corporate governance and increased earnings requirements. In (Brau & Fawcett, 2006) they find that CFOs main reason to remain private is to preserve decision- making control and ownership. The lack of ownership concentration undermines investors ability to monitor the companies management, and investors may discount the price they are willing to pay to reflect the loss of control (Allison, Hall, & McShea, 2008). In the interview (IPO Lawyer, 2014) it is stated that experienced legal counsel can assist the company in developing a positioning strategy and legal framework to ensure future success of the company. Conflicts of interests between the short- term interests of shareholders and the long- term interests of the company can be aligned through creating procedures and institutional structures that can reduce risk by either minimizing asymmetries or aligning incentives. Law firms can also advise the issuer on tax efficient structures for the business. They can provide advice on employment agreements, employment policies, executive compensation and benefit plans to attract and retain key personal. Law firms can also provide contact with accountants, investment bankers and other service providers that can assist the company in realizing the growth potential of their businesses by providing access to deal flow and other opportunities. (FERRIS, HAO, & LIAO, 2012) examined prospectus conservatism and found evidence that conservatism in the prospectus is significantly and inversely related to the industry- adjusted return on assets for 3 years following the IPO. Experienced legal counsel may be less conservative in the prospectus and therefore investors may obtain a higher return on their investment given a higher ranked and more experienced law firm. 12

14 Section 3: Hypothesis and methodology Introduction The analysis of data is conducted using Logit and standard OLS regression to determine the effect of the independent variables. This study measures law firm prestige (LFP) by peer review ranking in equity offering section in the US published Legal 500. (Legal 500) Law firms classified as top tier, second tier, third tier and fourth tier are given the score of 1, 2, 3 and 4 respectively, while those which are not included in the top four tier list are given score of 5. To rank the prestige of the investment banks this study uses the Carter & Manaster rating updated by Loughran and Ritter (Loughran & RItter; Ritter, 1991). The investment banks are rated over 5 time periods: , , , and The more frequently an investment bank appears in the top bracket as managing underwriter, the higher rating is assigned to it on a 9- point scale. Hypothesis 1 The prestige of the US Law Firm representing the issuer will decrease informational asymmetry. Underpricing = c + β 1 * Law Firm Prestige + β 2 * Prospectus Size + β 3 * Legal expenses + β 4 * Number of Investment Banks + β 5 * Investment bank Prestige + β 6 * Investment bank Prestige 2 + β 7 * NASDAQ return + β 8 * Retain + β 9 * Venture Backed + β 10 * Change NASDAQ Avg2weeksprior + β 11 * FT + β * Offersize + β * Number of IPO β * Year Control + β * Industry Control +ε Underpricing is measured as the percentage change in price from the initial offer price to the first closing price in the secondary market. The independent variables are similar to those used in the existing literature examining the effect of intermediaries prestige on IPOs. As a proxy for complexity I will be using a word count of the prospectus, number of investment banks (IB), legal expenses and proceeds of the IPO (logged) as a proxy for the size of the offering. The prestige of investment banks (IBP) is included as they from previous literature signal the quality 13

15 of the issuer to the market, as a result decreasing underpricing. I also include the investment bank prestige squared to account for non- linear relationship. According to Leland and Pyle, the percentage of common stock retained by pre- IPO shareholders reveals the quality of the firm. In the article (Hanley, 1993) also includes retention of shares as a proxy for pre- offer demand. Strong pre- offer demand should result in relatively more underpricing of the IPO. According to Megginson and Weiss (1991), venture capital funds perform an influential monitoring function in the IPO process and provide assurance of the issuer s quality. The participation of venture capital is expected to signal better quality and therefore reduce underpricing. Venture- backed IPOs are coded as 1. In other literature scholars find that issuers are more underpriced in hot markets. Market status is therefore taken into account in the underpricing regression to exclude the hot market timing effect. The market status is measured as the return of the NASDAQ index over listing day and year control. To control for the hot business effect SIC two digit codes (Industry codes) are included. FT (Filing time) is included as a variable because it was presented as a significant factor in the interview (IPO Lawyer, 2014) and (Hanley, 1993). Filing time can be prolonged if the final offer price is lowered below the initial range or if less experienced company counsel is not able to time the process efficiently. Filing time can determine whether the issue is timed advantageously. Number of IPOs per year is included to determine whether an increased number of filings affect underpricing. Change in the NASDAQ average two weeks prior to issue is included as (Hanley, 1993) finds that changes in the market from the filing of the preliminary prospectus to the issue date are positively associated with changes in the offer price. Increases in the offer price are associated with a rise in the market index during the waiting period and final offer prices are decreased when the market falls. 14

16 Hypothesis 2 Legal fees decrease in periods of crisis Legal Expense = c + β 1 * Prospectus size + β 2 * Investment bank prestige + β 3 * Offer size + β 4 * Law Firm Prestige + β 5* Retention + β 6 * Filing time + β 7 * Number of IPO + β 8 * COLD1 + β 9 * HOT2 + β 10 * COLD2 + β 11 * HOT3 + β * Industry Control + ε (Beatty & Welch, 1996) find that legal firms are compensated for the reputation, the workload and risk proxies. I therefore formulate the regression on legal expenses based on law firm s reputation, the complexity of the deal, offer size, service market demand and firm specific risk. To examine whether law firms act differently in hot and recession markets, this study further divides data into five sets based on the economic status , and are hot markets and and are recession markets. I have chosen the period (HOT1) as the base period. Pre- IPO retention of shares is included as (Beatty & Welch, 1996) find that lawyers are paid less when insiders retain more of their earnings. (PWC, 2012) finds a positive correlation between the amount of costs incurred in the IPO process and the length of time from the initial filing to the effective date. Number of IPOs per year is included to determine whether demand affects legal fees. Hypothesis 3 The prestige of the US Law Firm representing the issuer will decrease the probability of withdrawal. Withdrawal = β 1 * Law Firm Prestige + β 2 * Number of IB + β 3 * Offer size + β 4 * NASDAQ return + β 5 * Legal Expense + β 6 * Prospectus size + β 7 * Investment bank prestige + β 8 * Investment bank prestige^2 + β * Year Control + β * Industry Control + ε 15

17 A logit regression is used to assess the probability of withdrawal based on law firm prestige. Withdrawn IPOs are coded as a dummy variable, 1 for withdrawn IPOs. Proceeds of the IPO (logged) are included as a proxy for offering size. The prestige of the investment bank is included as they can increase the level of confidence in the IPO by signaling the quality of the issuers to the market. This is consistent with the study performed by (Dunbar, 1998). To control industry risk I also include SIC two digit codes (Industry codes). Year control and return of the NASDAQ index on issue is included to control for market status. I also include the investment bank prestige squared to account for non- linear relationship. Legal expenses and prospectus size are included as proxies for complexity. Hypothesis 4 The prestige of the US Law Firm representing the issuer will affect long- term growth after the IPO. Mean total growth = β 1 * Law Firm Prestige + β * Investment bank prestige + β 2 3 * Offer size + β 4 * Venture backed + β 5 * Standard Deviation + β 6 * Underpricing + β 7 * Legal Expenses + β 8 * Number of IPO + β 9 * COLD1 + β 10 * HOT2 + β 11 * COLD2 + β 12 * HOT3 + β * Industry Control + ε Consistent with previous literature offer size control is included. Because larger IPOs are often done by well established firms, the risks should be diminished and therefore the initial returns should be smaller. Retention of shares is included to reflect pre- offer demand according to (Hanley, 1993). The standard deviation of the IPO stock returns is added to reflect the riskiness of future cash flows, consistent with (Hanley, 1993). To examine whether law firms act differently in hot and recession markets, this study divides data into five sets based on the economic status ,

18 2007 and are hot markets and and are recession markets. I have chosen the period (HOT1) as the base period. The participation of venture capital is expected to signal better quality and is therefore included as variable. Underpricing is included as a control variable to see if initial returns affect long term growth. To control for industry risk SIC two digit codes (Industry codes) are included. Section 4: Data, empirical results, and discussion Data The primary data used in this study are collected from Thomson One database. All IPO transactions including all security types for the time period 1990 through 2012, sold in all US Equity Markets. As a measurement for law firm reputation data is collected from Legal 500. Published for over twenty years, the Legal 500 Series provides the most comprehensive worldwide coverage currently available on legal services providers, in over 100 countries (Legal 500). The data on the issuer s prior legal representation in M&A deals and data on prospectus size is provided by professor Jens Martin of the Amsterdam Business School. The data on prospectus size comes from Edgar (SEC database) and is word counted. The data on prior M&A deals for the issuer firm and its legal representation comes from the Thomson banker one, it is then merged with the IPO data and compared by hand to see whether the legal representation is the same for the IPO and prior M&A deals. For long- term returns The Eventus database is used to collect data on company three year equally weighted returns adjusted over the SP500 after the issue. Summary Statistics Table 1 shows summary statistics for the regression tests. The sample mean of law firm ranking is 4.42, this means that the majority of law firms in this sample are not in the legal 500 top 4 tiers (Rank 5). The average filing time is 114 days; this is within the general range of 3-6 months. The mean of legal expenses are USD , from table 2 there is a growing trend in IPO legal expenses. Legal fees are stable in the , but increase substantially from (Allison, Hall, & McShea, 2008) Find that this trend of increasing IPO expenses can be attributed to more stringent 17

19 corporate governance requirements and regulations resulting from the Sarbanes- Oxley Act of The mean of offering size is $134.4 for the full sample. The reason this number is larger then in other literature is mainly because this study includes ADR s, close- end funds and REITS. The average underpricing was in the full sample 17.97%, and in the reduced sample for long- term growth, this is just below the U.S. average underpricing of 18-20%. The mean of pre- IPO shareholder retention is 0.56%, this is lower than other literate shows. This is due to the retention rate of REITS and close- ended funds are zero, which lower the average retention. Venture backed IPOs account for 30% of the sample. From table 3 you can see summary statistics by law firm ranking. The mean size of the offering is decreased for every drop in rank. The average prospectus is words for all ranks, from the mean by rank there does not look to be a pattern in size. The mean of filing time is lower for the top two tiers (Rank 1 & 2). The mean of underpricing is lower for all law firms included in the top four tiers of the legal 500. Data analysis The results of the regression outputs are shown in tables 5 to 8. Prestige and underpricing Output from the estimation of underpricing show that law firm prestige is negatively related to underpricing just below the 90% confidence interval (P value 0.118). For every increase in rank underpricing reduces with 1,13 %. A possible explanation is that experienced law firms provide more correct disclosure, and therefore reduce informational asymmetry. This leads to more informed decisions on the pricing of the issue conducted by the underwriter. (Barondes & Sanger, 2000) found that the prestige of lead managers counsel had a negative impact on the offer price and that this can translate to less underpricing due to partial adjustment. Another explanation is that less experienced law firms are more conservative in the prospectus. (FERRIS, HAO, & LIAO, 2012) examined prospectus conservatism and found evidence that prospectus conservatism is positively related to underpricing. The length of the prospectus shows no statistical significance on underpricing. This may be related to the prospectus serving several functions in the IPO. 18

20 The results from the return of the NASDAQ index over the offering day shows that the first day return of the IPO is related to market performance. Market timing is important factor in the success of the IPO. From (Brau & Fawcett, 2006) CFOs reported overall market conditions to be the number one constituent when timing an IPO. The percent change in the NASDAQ index two weeks prior to the offer date is positively and significantly related to underpricing. An increase of one percent in the index mean during the two weeks prior to issue translated into a 0,6% increase in underpricing. This is consistent with (Hanley, 1993) were increases in initial returns are associated with positive changes in the market during the waiting period. There is a positive correlation between underpricing and venture backed IPOs, the coefficient of 6.41 means that on average companies with venture capital are underpriced by 6.41% more then companies without venture capital. This is inconsistent with the theory that venture backed IPOs signal lower risk, as venture capital firms monitor their investments. The negative coefficient between underpricing and retention is not significant but is consistent with the hypothesis presented by Leland and Pyle. The hypothesis states that the percentage of common stock retained by pre- IPO shareholders reveals the quality of the firm. The greater the pre- selling activities to regular investors, the more likely it is that information is revealed about the true value of the issue. The results show a negative relationship between investment bank prestige and underpricing. This is consistent with prior academic research. The coefficient of - 7,73 means a decrease in underpricing by 7.73% for one increase in prestige. This indicates that a prestigious underwriter signals quality of the issue. (Hanley, 1993) suggests that this can be attributed to either the experience of the underwriters in evaluating the true value of the firm or that larger and more experienced underwriters are able to sell to a greater pool of informed investors who provide valuable information during the waiting period. Investment bank prestige squared shows a convex function, meaning that the influence of investment bank prestige on underpricing is decreasing with higher rank. Number of investment banks associated with the IPO decreased underpricing by 2.47% for every additional syndicate investment bank. Number of IPO conducted in the year of issue, offer- size and legal 19

21 expenses show no statistical significance. Legal fees in crises Results from the regression show that prospectus word count is a good indicator of legal fees. A longer prospectus is associated with higher legal fees, for every 100 words there is an increase in legal expenses of USD As it is does not have a significant relationship with underpricing it suggests that size of the prospectus has several functions, both formal and informal. A longer prospectus can be related to offerings in several jurisdictions, more complex structure, more risk and as a promotional document. Filing time, is the time it takes from the initial filing to issue. The filing time has statistically a significant relationship with legal expenses. This is consistent with the interview (IPO Lawyer, 2014) and (PWC, 2012). For a one- day increase of the filing period there is an additional cost to the issuer of USD 793. The percentage retention of shares is also statistically significant but negative, meaning that legal expenses decrease if pre- IPO shareholders retain more stock. Number of IPOs conducted has a statistically positive relationship on legal fees; this suggests that legal fees increase with the number of IPOs. Investment bank prestige shows a negative relationship with legal expenses at the 1% significance level, for every increase in rank, legal fees decrease by USD This shows that an investment bank with higher prestige have more experience with the IPO process and can coordinate better with issuers law firm. The proxy for experience represented by law firm ranking is in not statistically significant, but shows increasing legal expenses with one increase in rank. The test shows a statistically significant increase in IPO mean price in the crises 2008 to 2009 compared to the base period hot1 ( ), this is surprising if you look at theory on demand and supply that suggest that a lower number of IPOs should decrease the demand for IPO legal expertize. As companies have a higher bargaining power the optimal price level for legal services related to IPOs would be at a lower level. This is also consistent with a higher number of IPOs showing higher legal expenses. This might imply that either IPOs in recession are more complex and require longer filing time or that in recession there is a high demand for legal 20

22 expertize in other legal areas, leaving more specialized law firms to conduct IPOs. Offer size has no statistical significance in this sample. Law Firm prestige and withdrawal In the logit test for withdrawn IPOs, law firm and investment bank prestige increase the probability of a withdrawn filing. Changes in market status and company specifics during the filing may reduce the demand for the stock. Highly ranked law firms and investment banks with experience in the IPO process might have a better ability to evaluate whether these changes may affect the chance of a successful IPO. By withdrawing the filing if the chance of success is considered too low the impact on reputation is reduced. This may indicate that the price of the filing is important for the reputation of the investment bank and law firm. The variable investment bank prestige squared shows a concave relation with withdrawal, meaning that the probability of withdrawal based on investment bank prestige will be increasing with rank but at a decreasing rate. Prospectus size shows a statistically decreasing probability of a withdrawn filing with a longer prospectus. Legal fees are not statistically significant but show a decreasing probability with increase in legal fees. Less experienced legal counsel may put more work into the IPO to ensure that the company goes public, but are less focused on the market timing and the price of which the company is sold. Number of investment banks also decreased the probability of a withdrawn filing. The pooled experience of syndicate may give the issuer a better chance of a going public. Law Firm prestige and company long- term growth Law firm ranking shows a positive relationship with long term growth. For every increase in rank there is an increase of in the mean three- year return adjusted for the SP500. This supports the interview (IPO Lawyer, 2014) in that legal counsel can assist the company in developing a positioning strategy and legal framework to ensure future success for the company. Further support for this view is it that an increase in legal fees also shows a positive relation with long- term growth. Prospectus conservatism may also be an explanation, (FERRIS, HAO, & LIAO, 2012) found that prospectus conservatism is significantly and inversely related to the 21

23 industry- adjusted return on assets for 3 years following the IPO. Experienced legal counsel may be less conservative in the prospectus. Prospectus size shows a negative correlation with long run return at the 5% significance level, as the prospectus serves both formal and informal functions it is hard to attribute this to a specific theory. More complex, or less popular issues, may require increased promotion. This may increase the size of the prospectus. Lack of performance may require a longer prospectus to ensure that all necessary information is disclosed to potential investors. Standard deviations of the returns are positively and statistically significant indicating that higher standard deviation increases the return in the long run. This is consistent with previous literature. Venture backed IPOs are in this sample statistically significant with a negative relationship, this might indicate that when the venture capital firm exits the company through the IPO the peak of performance and markets conditions. This is consistent with (Ritter, 1991) in that the long run performance of the company after the IPO are on average low, due to the company engaging in an IPO at the peak of performance and market conditions. The positive relationship with underpricing is surprising as (Ritter, 1991) presents some evidence that firms with high- adjusted initial returns tend to have the worst aftermarket performance. He attributes his findings to potential overreaction in the market for IPOs and suggests that this result may shed light on the partial adjustment phenomenon. There is a statistically positive relationship with both hot and cold market conditions compared to the variable HOT1 ( ). The variable indicates that companies issued in the period 1990 to 2000 had worst aftermarket returns. Investment bank prestige, number of IPOs and offer size is not statistically significant in this sample. Robustness Check In table 9 of the appendix the data provided on issuer s legal representation in prior M&A deals was integrated into the legal fees and the long- term growth regression as a dummy variable, coded as 1 if legal representation was the same for the IPO and prior M&A deal. The inclusion shows no statistical significance, this may be attributed to missing data and issuers counsel assisting the company in other legal 22

24 aspects then M&A transactions prior to the IPO. In the regressions of table 9 the base period for comparison was Hot2 ( ). This shows that fees were higher in cold2 (2008 to 2009). The long- term growth regression shows only a statistical significance with other periods then Hot1 ( ). Implying that in our sample the IPOs issued between 1990 and 2000 had the lowest aftermarket returns. This study has included prospectus size as a proxy for complexity, as the prospectus serves several functions in the IPO it is hard to distinguish between the effect of promotion and the effect of complexity. Also the prospectus can be different in terms of conservatism as we see from (FERRIS, HAO, & LIAO, 2012). In the regression on underpricing hot and cold markets were initially included instead of year control, showing a lower explanatory power. This shows that IPO underpricing varies more by year then by market status of the period. Withdrawn IPOs were limited in the IPO data, and therefor should be subject to further study and inclusion of company specifics that could affect the probability of withdrawal. The inclusion of FAMA French multifactor model in the regression for long term growth could greatly enhance the quality and explanatory power of the regression. Company specific indicators for growth would also better the understanding of what type of company that is enhanced by greater law firm experience. The prestige of the law firm prestige is ranked according to the legal 500 (2012) ranking. The data collected on IPOs are from 1990 to 2012, which means that there may be changes in the prestige of law firms over the sample range. This may give less explanatory power of law firm prestige in the regressions. Section 5: Concluding section Through the initial public offering companies can raise the capital needed for further growth. A successful IPO consumes time and energy from both management and the company in general. A good company counsel will ease the process for the issuer by guiding the issuer and the shareholders steadily through the process. This is one aspect of added value that is not quantified in the paper. 23

25 The aim of this thesis was to look into value created by the issuing company s law firm. Analysis of data has been conducted on IPO data from the US equity market for the period 1990 to The prestige of the law firm prestige is ranked according to the legal 500 (2012) ranking. The explanatory power of the variable law firm prestige may have been higher if regressed over a shorter time period. The effect of law firm prestige on underpricing show that more experienced law firms reduce underpricing, just below the 90% confidence interval. A possible explanation is that experienced law firms provide more correct disclosure, and therefore reduce informational asymmetry. Consistent with prior literature the results show a negative relationship between investment bank prestige and underpricing. To estimate the impact of market status on legal fees this study divided data into five sets based on economic status. According to supply and demand theory legal fees decrease in recession markets with a lower number of IPOs, as companies have a higher bargaining power. Surprisingly regression outputs show a statistically significant increase in IPO mean price in the recession of 2008 to This may imply that either IPOs in recession are more complex and require longer filing time or that in recession there is a high demand for legal expertize in other legal areas, leaving more specialized law firms to conduct IPOs. The logit test for withdrawn IPOs show surprising results. Increase in ranking of both the law firm and the investment bank increase the probability of a withdrawn filing. Changes in market status and company specifics during the filing may reduce the demand for the stock. Highly ranked law firms and investment banks with experience in the IPO process might have a better ability to evaluate whether these changes may affect the chance of a successful IPO. By withdrawing the filing if the chance of success is considered too low the impact on reputation is reduced. This may indicate that the price of the filing is important for the reputation of the investment bank and law firm. 24

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