Do the Individuals Closest to Internet Firms Believe they are Overvalued?

Transcription

1 Do the Individuals Closest to Internet Firms Believe they are Overvalued? Paul Schultz and Mir Zaman * Abstract Two explanations are commonly offered for the large number of recent IPOs by Internet firms; that they are rushing to go public when Internet stock prices are irrationally high, and that they are trying to grab market share in an industry with large economies of scale. We examine the actions of Internet firm managers, underwriters and venture capitalists to determine their motives for going public. Mergers and acquisitions provide strong evidence of a rush to grab market share. Evidence that they are trying to sell overpriced stock is much weaker. June, 2000 Very preliminary. Please do not quote without the authors permission. We are grateful for the comments of Thomas George, Timothy Loughran, Paula Tkac, and seminar participants at the University of Iowa and the University of Notre Dame. An anonymous referee s comments were particularly helpful. Marina Bulyguina provided invaluable research assistance. Zaman is grateful to the graduate college at the University of Northern Iowa for a summer research fellowship. Errors are sole property of the authors. * University of Notre Dame and University of Northern Iowa respectively.

2 1. Introduction The recent hot issue market for Internet initial public offerings (IPOs) is an unprecedented phenomenon. During the fifteen months from January 1999 through March 2000, 321 Internet companies went public, with an average offering size of $86 million, and an average underpricing of 91%. Most of these companies had little revenues. Only 28 of the 321 were profitable in the previous quarter. Many had been in business for only a few months. Two explanations are commonly offered for the large number of recent IPOs of Internet firms. The first is that managers are hurrying to take their companies public to take advantage of the market s irrational overpricing of Internet stocks. One example of a stock with a price that seems to many to be too high to be justified by economic fundamentals is Amazon.com, whose market capitalization at the end of 1998 exceeded that of all traditional U.S. bookstores combined. Others dispute the irrational overpricing hypothesis, proposing that the prices of these stocks are reasonable given the tremendous growth and enormous potential of the Internet. Schwartz and Moon (2000) note that... if the initial growth rates are sufficiently high, and if there is enough volatility in this growth over time, valuations can be what would otherwise appear to be unbelievably high. In Amazon s case revenues increased 938% in only two years, from $37.9 million in the third quarter of 1997 to $355.8 million in the third quarter of The second explanation given for the recent outpouring of Internet IPOs is that companies are rushing to grab market share in an industry in which economies of scale ensure that only a few firms will survive. Kevin O Connor, CEO of DoubleClick, says There are two options for Internet companies, get bigger fast or get smaller fast. If you re not one of the top three players in any category, eventually you ll be eaten - or die. Of course, these two explanations are not mutually exclusive. Internet companies can rush to go public both because they believe Internet stock prices are too high and because they want to grab market share. Nevertheless, it is hard to overstate the importance of trying to distinguish between these two motives for going public. If the market has allowed firms to issue equity to take advantage of irrationally high prices for Internet stocks, the U.S. capital markets misallocated billions of dollars during the 1990's. On the other hand, if Internet firms have been 1

3 rushing to go public only to grab market share, the U.S. capital markets have functioned with tremendous insight, providing the wherewithal for an entirely new and revolutionary industry to arise in just a few years. In this paper, we examine the actions of the people who are closest to these companies for evidence on their motives for going public. Results from examining managers actions provide only weak support for the hypothesis that they are going public to sell overpriced stock. If managers believe their company s stock is overpriced at the time of its IPO, they should attempt to sell as many of their personal shares and to raise as much new capital as possible. However, we find that insiders sell fewer of their own shares in Internet IPOs than do insiders in other IPOs, and that Internet firms usually sell a smaller proportion of their equity in the offering than do other firms. We would also expect managers who believe their shares to be overpriced to attempt to sell additional shares through seasoned equity offerings. However, after adjusting for aftermarket performance, evidence that Internet companies are more likely to conduct seasoned equity offerings (SEOs) than other recent IPOs is weak. On the other hand, SEOs by Internet firms are larger than SEOs from other firms with recent IPOs. Although we find little evidence that managers are selling either their personal holdings or their companies shares at an unusual rate, our findings do not directly address the question of whether Internet stocks are overpriced. There is considerable academic evidence that entrepreneurs are usually unrealistically optimistic, and this could explain why we do not observe more selling. However, our evidence does weigh against the more sinister version of the irrationally overpriced IPO hypothesis in which smart managers and underwriters take advantage of the public. We also study the actions of underwriters and venture capitalists. Both groups access the capital markets repeatedly. Reputational capital acquired through involvement with previous IPOs is critical to their business. Thus they have a strong incentive to avoid involvement in IPOs they believe to be irrationally overpriced. We find that they do not avoid Internet firm IPOs. In fact, venture capitalists are far more likely to be involved with IPOs of Internet firms than other IPOs. Similarly, Internet IPOs are much more likely to be underwritten by the most reputable underwriters than are other IPOs. 2

4 In contrast, our evidence that managers are taking Internet companies public to grab market share is strong. Internet firms make acquisitions at a much greater rate than other recent IPOs and the acquisitions are either other Internet firms or firms that will contribute to their Internet business. Also, Internet firms enter into far more strategic alliances with other firms than do other recent IPOs. The remainder of the paper is organized as follows. In Section 2 we describe the characteristics of the market for Internet IPOs and show why many people consider these stocks to be irrationally overpriced. In section 3, we discuss the irrational pricing hypothesis and the idea that Internet firms are rushing to go public to grab market share. In section 4 we examine the actions of managers of Internet firm and whether they are consistent with the managers believing that their stock is overpriced. In section 5 we see whether investment bankers and venture capitalists act as if they believe Internet IPOs are overpriced. In section 6 we examine the hypothesis that Internet firms are rushing to go public to reap first-mover advantages and economies of scale. Section 7 offers a summary and conclusions. 2. Characteristics of the Market for Internet IPOs 2.1 Our Sample Internet stocks are stocks of companies that derive the majority of their revenue through sales over the Internet or by providing equipment, software, or expertise for individuals or businesses to access the Internet. It is difficult to identify Internet stocks because they carry numerous two-digit SIC codes. For example, the SIC code for Yahoo is 73, while Etrade s is 62, Amazon.com s is 59, and Priceline.com s is 47. Our first step in obtaining a sample of Internet companies is to include all stocks that went public between January 1, 1996 and March 31, 2000 that are in the Internet Stock List maintained at This list includes only currently traded Internet stocks. We supplement this by examining all IPOs from 1996 through March 2000 listed in the Securities Data Corporation files and including them if they listed 3

5 Internet in the description of their primary business. We also examined company descriptions of sample IPOs in Finance.yahoo.com to see if they were described as Internet stocks. After excluding unit offerings, we have a sample of 420 Internet stocks that went public between January 1996 and March We also obtain a sample of 1,905 other IPOs from the same period. We exclude all mutual funds (SIC code 67) as well as all unit offerings from this sample. Information on IPOs is obtained from Securities Data Corporation (SDC). For each IPO we get the filing date, first trade date, underwriter spread, offering price, the filing price range, the lead underwriter, the SIC code, the total number of shares offered, the number of primary shares offered, aftermarket capitalization, earnings before interest and taxes for the previous 12 months, the book value per share following the offering, the market value after the offering, the number of days the lockup provision is in effect, the value of assets, whether the offering had venture capital backing, and total aftermarket returns from the offering to four weeks, 60 days, 90 days and 180 days afterwards. Aftermarket prices are the closing price on the first day of trading. When aftermarket prices from SDC are compared to first day closing prices from CRSP they do not always match, suggesting that SDC aftermarket prices are not always accurate. Thus aftermarket prices are obtained from CRSP for 1996 through Other questionable data from SDC were checked, when possible, against SEC filings. 2.2 Internet companies have been rushing to go public Fig.1 shows the number of Internet IPOs and the number of other IPOs obtained from SDC for each month from January 1996 through March In general, this was an active period for IPOs. Before the fall of 1998, there is almost always at least 25 IPOs per month. There is typically one to five Internet IPOs. In late 1998 and early 1999, the number of Internet companies going public accelerated. In each month from May through September of 1999, there were more Internet IPOs than all others combined. The number of Internet IPOs declined sharply in January 2000, but matched and then exceeded the number of all other IPOs in February and March In total, 420 Internet companies raised over $32.6 billion through IPOs during the 51 months of the sample period. 4

6 2.3 Internet companies go public at earlier stages than other companies Table 1 shows that Internet stocks go public earlier than other firms. Companies that go public at an early stage of their life-cycle are typically underpriced more than other IPOs. The mean underpricing for Internet IPOs is 80.7% while the mean underpricing of other IPOs is only 21.6%.The t-statistic for the difference is The difference in underpricing is not due to a few very large returns. The median underpricing of the Internet IPOs is 50.0%, as compared to 9.37% for other IPOs. Fig. 2 shows the mean underpricing of Internet firm IPOs and other IPOs for each month from January 1996 through March Mean underpricing of both Internet and other IPOs varies between about 5% and 25% from 1996 through This is near the historical average for all IPOs. From late 1998 on, underpricing for Internet IPOs increased dramatically. For each month from November 1998 through April 1999, the mean Internet IPO underpricing is over 100%. For the remainder of 1999, mean underpricing is about 50%, but then exceeds 100% again from December 1999 through February Fig. 2 also reveals that underpricing of non- Internet IPOs has increased sharply in late 1999 and Several months during this period have mean underpricing of other IPOs in excess of 50%. In part this may reflect ambiguities in determining which firms are Internet companies. For example, companies whose primary business is cable TV are not classified as Internet companies even though they may provide Internet access. Further evidence in Table 1 that Internet companies have been going public at an earlier stage in their life than other companies is that both the mean and median of the ratio of earnings before interest and taxes to market capitalization are negative for Internet stocks and positive for other IPOs. In fact, only 42 of the 420 Internet firms were profitable in the quarter prior to their IPO. Similarly, the mean ratio of book value per share to offering price is.295 for Internet IPOs and.366 for other IPOs. The mean ratio of book value to aftermarket price is.241 for Internet IPOs and.309 for other IPOs. Both differences are highly statistically significant. Perhaps the 1 There were no Internet IPOs in October 1998, so that month is omitted on the graph. 5

7 most striking difference is in the ratio of revenues to market capitalization. On average, previous year revenues of Internet companies were only 7.1 percent of market capitalization. For other companies, previous year revenues averaged 57.1 percent of market capitalization. It is interesting that underwriter spreads are similar for Internet stocks and others despite apparent differences in risk. Table 1 shows that the mean underwriter spread for Internet stocks is 6.98 percent while the mean spread for others is 6.85 percent. The convention of 7 percent underwriter spreads documented in Chen and Ritter (2000) is followed for 87.6 percent of Internet IPOs and 60.6 percent of others. 2.4 By conventional standards, prices of Internet stocks are high. Table 2 provides summary statistics on market capitalization, revenues and earnings for the sample of Internet stocks as of December 31, Closing stock prices are obtained from TAQ. Information on revenues, and sales for the last quarter ending on or before December 31, 1999 is gathered from This is also the source of outstanding shares. Those that claim that Internet stocks are irrationally overpriced frequently point to statistics like those found in Table 2. In total, the 299 firms in the sample that were publicly traded at the end of 1999 had previous quarter revenues of $8.20 billion and lost $4.95 billion. Despite this, their total market capitalization was $1,363 billion. 2 For comparison, IBM, Intel, Dell Computer, Amgen, Lucent Technologies and MCI Worldcom combined had a market capitalization of $1,083 billion, over $270 billion less than that of the Internet stocks. However, between them these traditional growth stocks had previous quarter revenues of $59.6 billion; more than 7 times that of all the Internet firms. Their earnings totaled $7.32 billion as compared to the loss of $4.95 billion by the Internet companies. The distribution of statistics for individual firms is particularly interesting. In the previous quarter, 86.3 percent of the firms lost money and 95 percent made less than $5.4 million. More than 25 percent of the firms had market capitalizations of more than $2.8 billion, but fewer than 2 Two of the biggest Internet firms, America Online and Cisco Systems, went public before 1996 and are thus omitted from the sample. 6

8 25 percent had previous quarter sales of $25 million and only about 10 percent had earnings greater than $900,000. The median firm had a capitalization that was 92 times the previous quarter s revenues. Perhaps the most interesting statistic is that for each dollar in revenues, the median firm lost 72. The high valuations attached to Internet firms with little or no sales or earnings has motivated several recent accounting studies that seek to explain the pricing of Internet stocks. A general conclusion seems to be that large losses of Internet firms are due to investment and that the market is capitalizing these losses. Hand (2000a) finds that larger losses are associated with greater market values; a finding consistent with investors treating marketing and R&D as investments rather than expenses. Trueman, Wong, and Zhang (2000) examine the pricing of two types of Internet stocks; e-tailers and portal and community firms. They find that net income is negatively related to the market value of the firms and that measures of Internet usage such as number of visitors to a site or page views were strongly positively related to market value. When net income is decomposed, they find that market value is positively related to both gross profit and research and development expenditures. 3. Explanations for the Frequency of Internet IPOs We have documented several findings about the hot issue market for Internet IPOs. First, Internet companies have been going public at a furious pace in 1999 and Second, these companies appear to be going public at a much earlier stage than other companies. Finally, we find that the total capitalization of Internet companies is high despite low sales and losses. In this section we compare two hypotheses that explain the high prices of Internet stocks and their rush to go public. The first is that these stocks are overpriced and they are rushing to go public to take advantage of a gullible public. The second is that the Internet is an industry with tremendous potential and that firms are going public in a hurry to grab first- mover advantages and market share. Of course these two explanations for Internet firms rush to go public are not mutually exclusive. A company going public to grab market share would be all the more eager to issue stock if they believed they were getting a price in excess of its true value. Likewise, a company 7

9 that saw an opportunity to sell stock at a premium would be especially eager to do so if it also conferred first mover advantages on the company. 3.1 Internet Stocks are Irrationally Overpriced There is widespread belief, among both academics and practitioners that the prices of Internet IPOs cannot be justified by economic fundamentals, and that managers and investment bankers are taking advantage of irrationally high prices to sell Internet stocks. An article in the New York Times on June 6, 1999 claims that As some of the air leaks out of the Internet stock bubble, the same people who manufactured the feeding frenzy - the venture capitalists, entrepreneurs and investment bankers who have been the biggest promoters of the phenomenon - are beginning to say it may have spun out of control. The Global View column of the April 4, 2000 Wall Street Journal stated that Whether millions of investors will wake up in time to get out before America s tech bubble bursts is the subject of feverish speculation these days. Indeed, an entire book espousing this view, The Internet Bubble has been written by Anthony and Michael Perkins, editors of the business magazine Red Herring. Contributing to the belief that the Internet IPOs are overpriced are the results of studies by Ritter (1991), Loughran and Ritter (1995) and many others that seem to show that recent IPOs significantly underperform other stocks of similar size in the same industry for five years after going public. Furthermore, offerings tend to cluster in time and their frequency diminishes after periods of poor performance. An interpretation of Ritter (1991) and Loughran and Ritter (1995) is that all recent IPOs, not just Internet companies, are priced irrationally A second piece of evidence cited by proponents of the irrational overpricing hypothesis is the market s seeming eagerness to reward companies who develop even the vaguest Internet strategies. Cooper, Dimitrov and Rau (2000) study a sample of 95 very small firms that changed their names to include.com or Internet. They find an average abnormal return of 80% for the ten days surrounding the announcement. They argue that their results are driven by a degree of investor mania - investors seem to be eager to be associated with the Internet at all costs. Further evidence consistent with irrational pricing is provided by Hand (2000b). He finds that while most 8

10 of the cross-sectional variation in values of Internet companies can be explained by accounting fundamentals and measures of web traffic, Internet stock valuations are correlated with what Hand (2000b) terms supply and demand variables. These include the short interest, the percentage of stock held by institutions, and the float, or number of shares outstanding not held by insiders. Hand (2000b) concludes that this is evidence that the... pricing of Net stocks may be less than fully rational. It should be emphasized that many adherents to the irrational overpricing hypothesis believe that rational corporate insiders and investment bankers take advantage of investors by timing equity sales for periods when stocks prices are too high. Loughran and Ritter (1999) observe that the clustering of IPOs could be explained by managers timing offerings to take advantage of temporary misvaluations. Shiller (1990) presents an impresario hypothesis in which underwriters discover when the public is ripe for fads in some area of IPOs. In his scenario underwriters severely underprice IPOs in this area to attract attention and create an impression that the underwriter knows what he is doing. This makes it easier to market future IPOs. Evidence consistent with this view is provided by Lerner (1994). He compares the timing of IPOs and private financings from venture capitalists for biotech firms over He shows that the mean level of a biotechnology index is higher when firms go public then when they receive private financing. Furthermore, the mean return on the biotechnology index is significantly higher in the 60 days leading up to an IPO than in the 60 days before a private financing. Conversely, the mean return on the biotechnology index is significantly lower in the 60 days after an IPO than in the 60 days after a private financing. Lerner (1994) concludes that venture capitalists, who are instrumental in determining when a firm goes public, are able to successfully time IPOs to coincide with market peaks. 3.2 A Rush to Grab Market Share An alternative explanation for the high prices of Internet stocks and the high volume of Internet IPOs is that firms are rushing to go public to garner market share in an industry with enormous potential. Grabbing market share can give an Internet firm a decisive advantage over 9

11 potential entrants for two reasons. First, the firm with the large market share may be able to charge more. Second, economies of scale imply that the company with a large market share will face lower costs than potential competitors. Smith, Bailey and Brynjolfsson (1999) (henceforth SBB) provide evidence that Internet retailers with large market shares charge more. They show that the dispersion of prices on the Internet for homogeneous goods such as books and CD s is similar to the dispersion observed across traditional retailers. They observe that online retailers with the lowest prices are typically the smaller ones while companies with larger market share, like Amazon.Com, can charge a premium. One explanation SBB offer for this finding is awareness. Search costs may be nontrivial on the Internet because of the large number of online retailers. SBB observe that neural real estate may be just as important in online markets as physical real estate is in conventional markets. The millions of dollars that Internet companies spend for premium locations on portals and for conventional advertising is consistent with this view. A second reason retailers with an established customer base may be able to charge more is that they can leverage switching costs to retain customers. This can be done through loyalty programs similar to the frequent flyer programs used by airlines. It can also be done by using information from the customer s previous purchases in conjunction with purchases by other customers to provide customized recommendations. A third reason established Internet retailers can charge higher prices is that these retailers are trusted more. SBB reveal that customers who utilize online shopping services often forego cheaper prices in favor of branded retailers like Amazon.com. Customers feel more confident that they will receive their order and receive it in a timely manner when dealing with a well known Internet retailer. To summarize, SBB s findings suggest there are significant first mover advantages may allow an early entrant who has established market share to charge higher prices than potential new entrants. Consistent with this, Rajgopal, Kotha, and Venkatachalam (2000) find that the market value of Internet firms is strongly positively correlated with the traffic that their websites receive even after adjusting for financial variables. However, current revenues are only weakly associated with web traffic. Rajgopal, Kotha, and Venkatachalam (2000) conjecture that traffic is valued because it creates future growth through customer relationships and network effects in 10

12 several ways. First, it provides data on the needs and desires of visitors to the firm s website. Second, the value of a website to a visitor may depend on how many others visit that site if visitors themselves generate content. Finally, an accumulation of data about visitors makes it possible for vendors and advertisers to tailor products and services to visitors, thus making the site even more attractive to visitors. The second advantage conferred by a large market share is lower costs. Many Internet companies are characterized by both low variable costs and high fixed costs for writing software, establishing databases and promoting their businesses. Jeff Bezos, CEO of Amazon.com observed in a May 22, 2000 Wall Street Journal article that The thing a lot of people don t understand about e-commerce is the degree to which it is a scale business. A conventional retailer may need to double costs to double sales, but Amazon s costs are mainly fixed. Once our software is written, we can handle a lot of customers with it. Under these circumstances, establishing a large market share early could be the key to success. An initial public offering helps Internet firms obtain market share in several ways. First, an IPO provides capital to allow a company to lose money for several quarters while it invests in marketing to achieve market share. Second, an IPO allows Internet firms to acquire other companies using either publicly traded stock or cash obtained in the offering. Finally, the IPO itself provides publicity and brand awareness for the firm. 4. Do Managers of Internet Firms Think their Stocks are Overpriced? 4.1 Do Insiders Sell as Much Stock as Possible in the IPO? If insiders believe their stock is overpriced, they would like to sell as much of their personal holdings as possible. The negative signal conveyed by insider selling may be expected to cause a revaluation of their stock. However, if the market is systematically ignoring or misinterpreting other information and overpricing Internet stocks, it is not clear that it would correctly incorporate the information that insiders were selling. As Stein (1996) observes, 11

13 ...given the premise of investor irrationality, one does not necessarily want to go to the other extreme - represented by rational asymmetric information models such as that of Myers and Majluf (1984) - and assume that the announcement effects of a share issue or repurchase are such that they, on average, completely eliminate the potential for market timing gains. Thus in Stein s view, signaling concerns suggest that insiders in Internet companies would not be able to sell as much stock as they like at the IPO, but would still sell more of their personal holdings than insiders in other IPOs. Muelbroek (2000) raises the point that insiders in Internet stocks should be especially eager to sell their personal holdings regardless of whether the stocks are overpriced because their holdings are particularly volatile. She examines insider sales for firms that made up the Hambrecht & Quist index of Internet firms over She finds that the mean annual standard deviation of these stocks is 113%. She then uses Sharpe ratios to show that for an undiversified investor (like a manager) in an Internet stock, the required return on an Internet stock must be more than twice the return required by a diversified investor. Thus managers can benefit from selling stock even if they know it to be underpriced by 50%. Meulbroek (2000) then shows that stock returns are actually slightly positive around sales of stock by Internet company insiders. She notes that this is consistent with the market recognizing that the desire for diversification can lead managers of Internet companies to sell their holdings regardless of whether the stock is under or overpriced. In examining insider trading, we are limited because most of our sample stocks are recent IPOs. In many cases, lockup provisions have not expired. Nevertheless, we examine sales of shares by insiders in IPOs and follow-on offerings. Caution must be used in interpreting these results however. Other vehicles exist that allow insiders to effectively eliminate the risk of their shares without selling. Some investment bankers have set up exchange funds for insiders from several companies. Each contributes shares and receives a fractional ownership of the fund. By entering into one of these funds, the Internet manager can effectively swap his own shares for a diversified portfolio. The appeal of an exchange fund is obvious to an insider who feels his stock 12

14 is overvalued. 3 Table 3 compares sales of equity in Internet IPOs with IPOs from the matched sample. Managers of Internet companies are less likely to cash out at the IPO than managers of other firms. Panel A reports raw data. On average, 96.9 percent of the shares in an Internet IPO are primary shares as compared to 87.5 percent for other IPOs. This difference is highly significant with a t-statistic of In addition, insiders in Internet companies retain, on average, 45.6 percent of their companies shares. Insiders in other firms on average retain only 39.7 percent of their companies equity. Finally, 95.7 percent of Internet offerings include a lockup provision as compared to 93.4 percent of other IPOs. In addition to selling more of their personal holdings, managers of Internet firms who believe their stock is overvalued should try to sell a larger proportion of their companies if they believe stock prices are too high. Table 3 shows that, on average, 27.9 percent of aftermarket shares come from the IPO for Internet companies, while 32.4 percent of aftermarket shares come from IPOs for other firms. Internet firms sell a smaller proportion of the company s equity when they go public than do firms in other industries. One reason why managers of Internet IPOs may sell fewer secondary shares is because these companies are typically at an earlier stage in their life cycle than most IPOs and managers may need to retain shares to avoid sending the wrong signal to potential buyers of the IPO. To test this we run logistic regressions in which the dependent variable takes a value of one if secondary shares were sold and zero otherwise. Independent variables include the stock s price to book ratio, the natural logarithm of the stock s market value, the ratio of earnings before interest and taxes to market capitalization, and the ratio of revenues to market capitalization. These variables are included to reflect differences in maturity and risk between Internet IPOs and others. A dummy variable that takes a value of one for Internet IPOs is also included. Results are reported in Panel B of Table 3. For comparison purposes, the first logistic regression has only one independent variable - 3 One Internet firm manager who did apparently believe her company was overvalued but did not sell shares at the IPO was Nina Brink. The prospectus for her World Online International reported she transferred shares to Baystar Capital about three months before the IPO. It was later discovered that Baystar paid only $6 per share (plus a percentage of profits from aftermarket sales) to Brink; far less than the $42 offering price. Baystar was not restricted by any lockup provisions and sold more than one million shares during the first three days of trading. 13

15 the dummy for Internet IPOs. The coefficient is negative and significant, indicating that a sale of secondary shares is less likely for Internet companies. In the second regression, the book to offer price ratio is negative and significant, natural logarithm of market capitalization is positive and significant, the ratio of earnings before interest and taxes to capitalization is positive and significant and the ratio of revenue to capitalization is positive and insignificant. The dummy variable for Internet firms remains negative and highly significant. Neither the coefficient nor the z-statistic are changed much by the inclusion of other variables. Insiders in Internet IPOs are less likely to sell their own shares in an IPO than are insiders in other IPOs. 4.2 Seasoned equity offerings of Internet stocks Of course, even if managers believe their stock is overpriced, the dramatic first day returns of Internet IPOs may persuade them to sell shares in seasoned equity offerings (SEOs). To test this, we match each Internet IPO with an IPO of a non-internet company that went public in the same month or one of the three months prior to the Internet firm s IPO. The non-internet IPO is selected to have offering proceeds as close as possible to the Internet IPO s. Each matching IPO is only used once. We obtain from SDC all seasoned equity offerings for the sample Internet firms and the matching firms from the time of their IPO through December We use a matched sample rather than comparing all Internet IPOs with all other IPOs because most of the Internet IPOs occurred much later in the sample period than most of the other IPOs. We would also expect that managers would be more likely to sell company shares in SEOs, all else equal, if the stock was overpriced at the IPO. Thus in addition to more sales by insiders in SEOs by Internet firms, SEOs should be more common for Internet companies than others if the Internet stocks are overpriced. Statistics on the seasoned equity offerings are contained in Panel A of Table 4. Internet companies do sell more stock through SEOs. In total, the Internet firms had 132 SEOs while the matching firms had 93. Some firms issued stock more than once, so 117 of the 420 Internet companies had SEOs as compared with 80 of the 420 matching firms. A chi-square test rejects a null hypothesis that equal proportions of Internet firms and matching firms had SEOs at 1 percent 14

16 confidence level. In addition, the SEOs of Internet firms raise about as much as their IPOs, while the average SEO of other firms raises only 75 percent as much money as the firm s IPO. The hypothesis that Internet stocks are irrationally overpriced predicts that insiders would like to sell as large a proportion of their personal holdings as possible in any SEO. The evidence on this is mixed. The last four rows of Panel A of Table 4 provides information on the proportion of shares sold in SEOs that were secondary shares. Both the mean and median percent of secondary shares sold in the first SEO are lower for the Internet firms than the others. The differences are not significant. When all SEOs are considered, the percent of secondary shares are almost identical for Internet IPOs and others. On the other hand, SEOs of Internet stocks tend to be larger. Thus in absolute terms, insiders are selling more shares. In comparing the frequency of SEOs for Internet firms with the frequency of SEOs for others, it is important to adjust for aftermarket performance. Jegadeesh, Weinstein, and Welch (1993) find that returns in the two 20 day periods following a firm s IPO are strongly positively related to the likelihood of a seasoned equity offering. This is consistent with what they term the market feedback hypothesis. A positive aftermarket return tells the issuing firm that the value of their projects is greater than estimated and that the scale of their projects should be increased. Note that if managers of Internet firms believed their shares were overpriced at the time of the IPO then, holding aftermarket performance constant, they would more likely to conduct SEOs. We estimate a logistic regression using the Internet and matching firms to see if a difference in aftermarket returns is behind the greater likelihood of seasoned offerings by the Internet companies. SDC provides the percentage price changes for four weeks, 60 days, 90 days, and 180 days following the offering. These price changes are used to calculate the return for the first four weeks, from the end of four weeks to 60 days, from 61 days to 90 days, and from 91 days to 180 days. The dependent variable takes a value of one if the firm had one or more SEOs and zero otherwise. The independent variables are the natural logarithm of one plus the returns over each period. An interaction term between the first four weeks return and whether the firm was an Internet company is also computed. The estimates are reported in Panel B of Table 4. The first logistic regression is estimated without return variables. In this case, the coefficient on the Internet firm dummy is positive with a z-statistic of Aftermarket returns 15

17 for the first four weeks are included in the second regression. The coefficient on the aftermarket return is positive and significant, implying that companies are more likely to conduct SEOs if their stock performed well following the IPO. The coefficient on the Internet dummy variable remains positive and significant, with a z-statistic of 1.98, suggesting that Internet firms were more likely to conduct SEOs than others even after adjusting for returns in the four weeks following the IPO. In the third regression, returns over each interval are included. Now, the dummy variable for Internet IPOs remains positive, but the t-statistic drops to When an interaction term between the Internet dummy and aftermarket return is included in the last regression, the coefficient on Internet dummy variable becomes negative and insignificant. After adjusting for aftermarket performance, the evidence that Internet firms are more likely to conduct SEOs is weak. 4 Panel A of Table 4 shows that proceeds from SEOs by Internet firms have been larger (relative to proceeds from their IPOs) than SEO proceeds for other firms. In Panel C we explore whether the difference in proceeds can be attributed to differences in aftermarket returns. The first two regressions have as a dependent variable the natural logarithm of the ratio of the proceeds from the first SEO to the proceeds from the IPO. The second two regressions use the natural logarithm of the ratio of the proceeds from all SEOs to the proceeds from the IPO as a dependent variable. In each regression, the dummy variable for Internet firms is positive and significant, indicating that SEOs by Internet firms are larger after adjusting for returns following their IPO. To summarize, we find that Internet firms do not sell more shares than are sold by other companies in IPOs, and managers of Internet firms do not sell more of their personal holdings than their counterparts at other firms. Similarly, after adjusting for aftermarket performance, the evidence that they are more likely to conduct SEOs than other companies that had gone public is weak. On the other hand, the Internet companies that conduct SEOs do sell more shares than other companies. 4 This test contains a small bias against finding that Internet firms are more likely to have SEOS. Each Internet IPO is matched with another IPO that took place in the four months up to and including the month of the Internet IPO. However, the concentration of Internet IPOs at the end of the sample period makes it impossible to obtain contemporaneous matches. 16

18 4.3 Overoptimism Why don t managers of Internet companies sell more stock? Even if they believed their stocks to be correctly priced, the tremendous volatility of these securities should induce riskaverse individuals to sell shares. One possibility is that they may be overestimating their chances of success. Heaton (1998) observes that a vast psychological literature demonstrates that people are too optimistic. For example, most people believe their chances of surviving a natural disaster are greater than those around them in identical circumstances. Optimism is most pronounced when people believe they can control outcomes and when they are highly committed to an outcome. Both of these conditions are likely to be met by managers of firms, and thus Heaton (1998) suggests that managers are likely to have upwardly biased assessments of their firms prospects. A similar psychological phenomenon is that people tend to be overconfident. For example, most people believe themselves to be better than average drivers. Camerer and Lovallo (1999) suggest that this may explain entry into new businesses when most new businesses fail. In experiments they show that subjects are far more likely to enter markets with negative expected payoffs if the payoffs are based on skill rather than chance. They conclude that people are likely to be overconfident in their abilities relative to their competitors. There is also strong evidence that entrepreneurs may be particularly susceptible to these biases. Evans and Leighton (1989) find that people who believe their performance depends largely on their own actions are more likely to start businesses, and individuals who believe they can control their own destiny are more likely to be overly optimistic. Cooper, Woo, and Dunkelberg (1988) survey 2,994 entrepreneurs and find that 81 percent believe their chances of success are at least 70 percent and 33 percent believe their success is certain. Of course, the great majority of new businesses fail. de Meza and Southey (1996) go so far as to say most of the facts characterizing small-scale businesses, including high failure rates... can be explained by a tendency for those who are excessively optimistic to dominate new entrants. Along with being overly optimistic, entrepreneurs are particularly overconfident. Busenitz and Barney (1997) ask managers and entrepreneurs a series of questions to test general 17

19 knowledge. While both groups were about equal in their accuracy, and both groups were overconfident in assessing the accuracy of their answers, entrepreneurs were significantly more overconfident. As a whole the psychological evidence indicates that managers of Internet firms are likely to believe that their firms chances of becoming the next Microsoft are far greater than they actually are. 5. Do Investment Bankers and Venture Capitalists Think Internet IPOs are Overpriced? 5.1 Are venture capitalists more likely to stake their reputations on Internet IPOs? Venture capital backing of initial public offerings is thought to provide certification of the IPO s value. Venture capitalists are typically involved with the IPOs of a number of companies. Acquiring and maintaining a reputation for backing quality companies enables the venture capitalists to bring them public more easily. This, in turn, brings more start-up companies to the venture capitalist. Consistent with the certification hypothesis, Megginson and Weiss (1991) find that, all else equal, venture backed IPOs are underpriced less and are charged a smaller spread by he underwriter. Similarly, Barry et al (1990) find that underpricing of IPOs is reduced with increases in the number of venture capitalists involved in the offering and the number of prior IPOs in which the lead venture capitalist participated. In Table 5 we compare the frequency of venture capital involvement in Internet IPOs with venture capital involvement in other IPOs. Panel A provides the raw statistics. Venture capitalists are involved in 66.2 percent of the 420 Internet IPOs but only 29.1 percent of the other 1,892 IPOs. The difference in the proportions is highly statistically significant. The heavy involvement of venture capitalists in Internet IPOs could simply reflect that these firms are going public at an earlier stage than others. To see if this is true, we run logistic regressions for venture capital involvement on a dummy variable that equals one for Internet stocks and variables meant to distinguish start-up firms from others. These variables are the price to book ratio, the firm s market value, and the ratios of earnings before interest and taxes and revenue to capitalization. The results of the regressions are shown in Panel B of Table 5. The first regression is reported for comparison purposes and includes only the Internet 18

20 Dummy. It is positive and highly significant, confirming that Internet firms are more likely to have venture capital backing. In the second regression, all variables are included. As expected, venture capital involvement is less likely as the market value of the firm increases, as the ratio of earnings before interest and taxes to capitalization increases and as the ratio of revenues to capitalization rises. However, even after inclusion of these variables, the coefficient on the Internet dummy remains positive with a z-statistic of Venture capitalists are far more likely to back Internet firms than others. If venture capitalist participation certifies IPO quality, they are strongly endorsing the Internet sector Are Internet IPOs Underwritten by Investment Bankers with Reputations to Protect? Underwriters, like venture capitalists, return to the initial public offering market repeatedly. Their desire to protect their reputation provides an incentive to avoid selling overpriced IPOs. Consistent with this, Carter, Dark and Singh (1998), and Michaely and Shaw (1994) find that IPOs underwritten by investment bankers with the best reputations perform better in the long-run than other IPOs. Panel A of Table 6 compares the percentages of Internet IPOs and other IPOs underwritten by six of the most prestigious underwriters; CS First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and Salomon Brothers. Hambrecht and Quist, which specializes in technology companies is also included. Results in Panel A reveal that 9.8 percent of Internet IPOs, but only 4.2 percent of other IPOs have CS First Boston as an underwriter. Or put another way, an Internet firm has a 9.8 percent chance of getting First Boston to underwrite their issue while other firms have only a 4.2 percent chance. Similarly, an Internet firm is significantly more likely to have Goldman Sachs or Hambrecht and Quist as an underwriter than another firm that is going public. Internet firms are also more likely than others to have Deutsche Bank or Morgan Stanley, but these differences are not significant. Internet firms are significantly less likely be underwritten by Salomon brothers than other firms. In the last two columns of the table, we compare the likelihood that an Internet IPO will 5 The certification hypothesis probably bears further examination in light of the findings of Lerner (1994). His results, that venture capitalists seem to be able to time IPOs for market peaks, implies that venture capital involvement is a signal that the IPO is a bad deal. 19

21 be underwritten by any of the top three underwriters 6 (Goldman Sachs, Merrill Lynch and Morgan Stanley) or the top six underwriters (all except Hambrecht and Quist) with the likelihood that another firm will be underwritten by any of these underwriters. The results are clear. Internet IPOs have a 24.8 percent chance of being underwritten by one of the top three underwriters and a 39.3 percent chance of being underwritten by one of the top six. For other firms, the likelihoods are 18.8 percent and 27.4 percent. Internet firms are more, not less likely to have prestigious underwriters. In Panel B, a series of regressions are reported. In each case the dependent variable takes a value of one if an IPO is underwritten by a specific underwriter or the top three or top six underwriters. The independent variables in the regression include a dummy variable for Internet firms and the natural logarithm of the operating proceeds. The results indicate that even after adjusting for the size of the offering, Internet firms are more likely to be underwritten by prestigious underwriters than others. These results contrast with those of Ritter (1984), who examines another hot issue market, the market for natural resource stocks in These IPOs, like the recent Internet IPOs had little in sale and earnings when they went public and were very volatile in the aftermarket. However, the natural resource stocks were typically underwritten by small Denverbased underwriters like J. Daniel Bell, OTC Net, and Securities Clearing of Colorado. The average proceeds for the natural resource offerings studied in Ritter (1984) was only $4.2 million while the average IPO in our sample has proceeds of $77.5 million Underwriters may attempt to protect their reputation by pricing Internet IPOs far below the price that they could obtain. This way, if the firm does poorly, the underwriter can point to the low price they assigned to the stock as evidence that the IPO that they brought out was a fair deal for investors. To test this, we regress the return from the offering price to the first day close on a dummy variable that takes a value of one for Internet stocks, the ratio of EBIT to market capitalization, the ratio of revenue in the 12 months before the offering to capitalization, the natural logarithm of the offering proceeds, and the ratio of offering price to book value per share, and a dummy variable that takes a value of one if the underwriters is among the top three or top 6 We thank the referee for help in defining the most prestigious underwriters. 20