Pre-IPO owners like founders, family members, angel investors, venture capitalists, and underwriters that assume ownership stakes in the firm as part of the IPO process in order to syndicate the offering and improve liquidity of the new stock, commonly have divergent interests. Some aspects of interest heterogeneity are summarized in Table I.
This table illustrates the variance among the interests of principals, including the time horizon of their investments, the importance of their ownership stakes in the IPO firm, and their loyalties to inside and/or outside entities. It also summarizes some of the effects of such interest heterogeneity on the IPO firm, which we discuss later in conjunction with our propositions. Briefly put, heterogeneity in each of these areas provides a source of potential conflict among the firm's principals. Insofar as principals exert control to resolve principal–principal conflict to their own private advantage, principal costs are likely to result.
Heterogeneity in Investment Time Horizon
Firm principals vary in the time periods over which they plan to hold their investments. Some have short-term plans and view the IPO as a chance to reduce their stake or exit completely, while others take a longer view and plan to maintain their stake indefinitely. Because the majority of pre-IPO owners retain some or all of their equity stake in the firm during the IPO process (Hill, 2006), we develop our arguments from the position that the majority of principals have mid- to long-term oriented interests. Accordingly, a pre-IPO principal who holds a short-term orientation would likely seek to induce firm agents to act in ways that run counter to the interests of most principals. As noted in our discussion surrounding Figure 2 above, this divergence of interests between owners can lead to principal–principal conflict. When powerful owners whose interests differ from those of other principals seek to manipulate the governance structure of the firm to their benefit, important governance tasks are likely to be neglected, the quality of firm governance will decline, and principal costs will result. We now offer several illustrations of principals who may hold short-term orientations that could lead to principal costs. We begin with venture capital firms.
When venture capitalists opt to make investments, they often consider significant time horizons (e.g. five or more years) in which specific returns may be achieved and harvested (Manigart et al., 2002). One common strategy for exiting high performing firms is to prepare them to undergo an IPO. Researchers find prestigious venture capitalists are influential board members (Fried et al., 1998) who are successful at involving reputable underwriters and facilitating IPO success (Gulati and Higgins, 2003; Shepherd and Zacharakis, 2001).
Venture capitalists, however, are not without limitations. By the IPO stage, most have short investment horizons in mind and seek to fully divest their stake in the firm in the years immediately following the IPO because the IPO is an exit strategy to fulfil their venture capital fund obligations (Brennan and Franks, 1997; Dalziel et al., 2011). Thus, it is in their self-interest to increase the liquidity of the firm's equity, a goal which may be accomplished by supporting the choice to underprice an issue, in view of increasing post-issue demand for the stock (Pham et al., 2003). Researchers also find that venture capitalists may sometimes use their influence on the board to encourage underpricing because their ability to raise future capital depends upon the number of IPOs they have facilitated. Accordingly, in their attempt to increase future cash flows, venture capitalists commonly ‘grandstand’ or promote underpricing to facilitate the completion of a stock issue to augment their personal track records (Gompers, 1996). In their analysis of Gompers' hypothesis, Lee and Wahal (2004) find empirical evidence that underpricing by VCs is associated with superior ability of the VC to raise funds for further investment from the market. The willingness of VCs to countenance underpricing – a practice that reduces the funds received by the IPO firm through the offering – is incongruent with the interests of most other pre-IPO principals who have a longer-term investment horizon with respect to the IPO firm.
To gain stock market interest in the IPO firms, VCs may also sometimes support activities intended to boost short-term performance (in order to make the IPO firm more attractive in the short-run) at the expense of long-term performance. Indeed, investors appear to at least partially anticipate VCs' short-term investment horizon because VC-backed stocks suffer an abnormal negative decline at the expiration of the lockup period, whereas IPO stocks without VC backing do not suffer the same abnormal decline (Bradley et al., 2001).
In addition to venture capitalists, a similar criticism extends to other short-term oriented principals. For example, an entrepreneur who wishes to relinquish ownership or control during the IPO may give the appearance of ‘bailing out’. This is likely to prompt concerns among potential investors that result in underpricing (Kroll et al., 2007), thereby deflating the value of the ownership stakes of other pre-IPO principals. Additionally, while business angels may have less relative ownership over time (as others such as venture capitalists have diluted their ownership position), they often have a strong incentive to exit their investment at the time of the IPO.
Similarly, some founding partners or other pre-IPO investors may have an interest in selling their equity in the firm and can use their influence to prompt agents to pursue an IPO in view of exiting. While such a decision might suit their self-interest (e.g. it might allow them to pursue other promising investment opportunities), it may be incongruent with the interests of investors who retain their stakes in the firm. Not only are these other equity holders unlikely to share in the opportunity and benefits that an exiting investor is pursuing, but the loss of inside owners (e.g. board members, founder executives) is likely to have a negative effect on the firm's value (cf. Wasserman, 2006). Supporting this view, researchers find a significant positive relationship between inside ownership and the stock price of an IPO (McBain and Krause, 1989) as well as the odds of firm survival after the IPO (Yang and Sheu, 2006).
In light of the above, we contend that short-term oriented principals may sometimes use their influence during the IPO process to promote actions which are detrimental to the interests of more long-term oriented principals. Formally stated:
Proposition 1: Heterogeneous investment time horizons among pre-IPO principals will be positively associated with principal costs in IPO firms.
Heterogeneity in Importance of Ownership Stake in the IPO Firm
While heterogeneous investment time horizons among principals are likely to result in principal costs, there are other factors that create conflict among principals which may also lead to principal costs. Heterogeneity in the importance of the ownership stake to principals is one such factor. For some (passive) principals, shares in the IPO firm are simply investment instruments designed to bring them financial returns, whereas for others they mean a great deal more.
For example, family member owners not only seek to profit financially from their investment in the firm, but they also receive a measure of ‘psychic income’ or an emotional reward by owning and controlling a firm with other family members (Gimeno et al., 1997; Miller et al., 2008). These owners may be reluctant to compromise these additional benefits (e.g. independence, family affiliation) by dispersing ownership and control to outsiders at the time of the IPO, particularly if they see the firm as a nexus of family identity and purpose. When family owners dominate the firm, they can use the business to care for family members. They can provide their loved ones with employment opportunities, generous access to firm resources, compensation, or perquisites.
This ‘parental altruism’ (Lubatkin et al., 2007) may deter them from relinquishing control to outsiders, particularly outsiders that are more likely to discipline excessive generosity, such as the powerful institutional investors that commonly buy IPO stocks (Hill, 2006). To the degree that family member owners seek to retain tight control of the firm, they may exert their influence on the board to derail or delay the IPO, despite the economic benefits that could accrue to themselves and other principals by going public. Where active venture capitalists, individual blockholders, or other early stage investors exert their influence to take the firm public, family members seeking to preserve family control can limit their support of the IPO process.
To illustrate, the hesitant principals might negotiate a smaller equity offering to curb the diffusion of ownership. Unfortunately, because smaller issues are known to increase the appearance of risk and the likelihood of underpricing (see Beneda, 2004, for a summary), this could reduce the wealth retained by principals, thereby creating principal costs. Family owners seeking to preserve family control commonly push for restricted voting privileges on the issue of common shares (i.e. dual-class equity). Since dual-class equity issues are less popular among investors than single-class issues and create conflicts among shareholders (Amoako-Adu and Smith, 2001), promoting them may have wealth consequences for other pre-IPO principals.
Our arguments concerning the importance of ownership to a family are also applicable to a founder with strong psychological ownership or attachment. Although committed founders are often critical to the long-term success of the organization (Fischer and Pollock, 2004), founders who maintain too much control can impede the professionalization of the organization. The need to balance the interests of founders with other principals is likely a reason why underpricing is more severe in an IPO firm when a founder-CEO dominates the firm or does not grant sufficient outsider representation on the board of directors (Certo et al., 2001a).
These and other similarly negative economic outcomes discussed above seem most likely when principals vary in how passionate or committed they are about their ownership stakes in the firm. In light of these negative economic consequences, we submit that when principals vary in their views of the importance of their stakes in the IPO firm, principal costs are likely to result. Formally stated:
Proposition 2: Heterogeneity in the importance of ownership to principals will be positively associated with principal costs in IPO firms.
In addition to having heterogeneous views of the importance of their ownership, principals also vary in the degree to which they are financially vested in the IPO firm. Some principals may stand to benefit more from the success of an outside entity than they do from the success of the IPO firm itself (Cable and Shane, 1997). In such cases, principals of the IPO firm may actually pursue suboptimal performance in the IPO firm to facilitate the success of this outside entity. We submit therefore that the heterogeneous loyalties of principals may be another source of principal costs.
Take for example, the underwriter of the IPO. The underwriter assumes a (transitional) ownership stake in the firm and sometimes appoints a representative to the board to facilitate the IPO process. As underwriters are influential principals who stand to benefit from seeing the firm go public, it can be easy to assume that they are likely to promote interests congruent with the majority of the firm's pre-IPO shareholders. Unfortunately, this assumption has limitations. An investment bank's returns are based on a portion of the gross spread (i.e. the difference between the price at which the underwriter buys and sells the issue) of each IPO it conducts. Thus, pre-IPO shareholders and investment banks essentially compete for future returns when they negotiate the price of an offering. Likewise, it may sometimes be in the interest of investment bankers to underprice offerings to develop their reputations and create future buy-side demand, though this is largely inconsistent with the interests of pre-IPO investors who do not share in these future benefits (Pollock et al., 2004).
Partial interest incongruence between an investment banker and the firm's other shareholders is also apparent in deal syndication, a common element of the IPO process in which the lead bank resells portions of the offering to other banks, who then share the responsibility of finding investors. While the IPO firm controls the choice of the lead underwriter, it has less control over the choice of banks to which the lead bank ‘floats’ the deal, the reputation of these banks, and the types of investors they rally (Ellis et al., 1999). Because the reputation of the banks involved and the roster of owners (Daily et al., 2003a) can influence IPO and post-IPO outcomes, a busy investment bank that satisfices syndication in the name of expediency may not maximize the interests of the firm's owners, leading to less wealth retention for principals at the time of the IPO (Certo et al., 2001a). Likewise, other principals may have idiosyncratic loyalties that significantly influence their preferred strategic outcomes for the firm. Such outside loyalties, when pursued strongly by the principals, will tend to result in principal costs. In view of these arguments, we submit the following:
Proposition 3: Heterogeneous principal loyalties will be positively associated with principal costs in IPO firms.