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  1. Top of page
  2. INTRODUCTION
  3. IPOS AND GOVERNANCE
  4. HETEROGENEOUS INTERESTS AMONG PRINCIPALS
  5. REVIEWING AND EXTENDING AGENCY THEORY
  6. HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS
  7. DISCUSSION AND CONCLUSION
  8. CONCLUSION
  9. ACKNOWLEDGEMENTS
  10. REFERENCES

The initial public offering (IPO) of a new venture's stock often results in significant changes to the firm's ownership structure. Because firm owners (principals) often have heterogeneous interests, conflicts can arise among the principals. While governance mechanisms are often effective in limiting agency problems, we suggest that principals can also attempt to use governance mechanisms to their own advantage in IPO settings. Specifically, when principal–principal conflict exists, powerful principals may exert control via governance mechanisms to pursue their own interests in ways that create inefficiencies in the form of ‘principal costs’.


INTRODUCTION

  1. Top of page
  2. INTRODUCTION
  3. IPOS AND GOVERNANCE
  4. HETEROGENEOUS INTERESTS AMONG PRINCIPALS
  5. REVIEWING AND EXTENDING AGENCY THEORY
  6. HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS
  7. DISCUSSION AND CONCLUSION
  8. CONCLUSION
  9. ACKNOWLEDGEMENTS
  10. REFERENCES

The initial public offering (IPO) is a ‘rite of passage’ in the life of an entrepreneurial firm (Champion, 1999, p. 17). Decisions made during this transition have far-reaching consequences for the growth and well-being of the enterprise. Factors that have been shown to have a significant influence on the future fortunes of the IPO firm include the ownership structure among principals of the firm, the changes in ownership that result from the IPO process, and the exit strategies of various principals.

For example, founder CEO ownership after an IPO is associated with IPO firm survival (Fischer and Pollock, 2004), and original top management team (TMT) board ownership is associated with superior post-IPO holding period returns (Kroll et al., 2007). On the other hand, although institutional ownership is generally beneficial to an IPO firm (Pollock, 2004), institutional owners are often positioned by the underwriting firm to realize a short-term gain by flipping their shares (buying at a low offer price and then selling shortly after the shares have shot up on the first day of trading) (Jenkinson and Ljungqvist, 2002). Underwriters have an incentive to price the shares of the IPO artificially low in order to attract these institutional owners for future deals (Arthurs et al., 2008). Even venture capitalists (VCs) maintain a short investment horizon at the time of the IPO and must develop their own exit strategy so that they can show returns to their own investors (in their venture capital funds) and syndicate affiliates (De Clercq et al., 2008).

It is our contention that these and other principals in the IPO process often possess heterogeneous interests that lead to interesting problems which are only now gaining prominence in the entrepreneurial governance literature. Conflicting interests among different owners in the IPO process can result in negative consequences for the IPO firm such as higher underpricing and lower capitalization (Arthurs et al., 2008). Indeed, the IPO process can be very structurally complex with several parties influencing the process to their own benefit (Pollock et al., 2004). As such, better understanding of the heterogeneous interests of different principals in the IPO process is an issue worthy of serious consideration.

The dominant paradigm used in studying the governance of heterogeneous interests in organizations is agency theory (Dalton et al., 2007). It focuses on the potential for conflicts of interest between principals and agents. Classic agency theory is primarily concerned with minimizing the opportunistic behaviour of agents (Jensen and Meckling, 1976; Perrow, 1986). However, more recent research is beginning to show that principals can be the cause of governance problems as well. For example, Villalonga and Amit (2006) find that powerful shareholders can extract private benefits for themselves at the expense of others. Similarly, Chang (2003) provides evidence that controlling principals can expropriate value from other shareholders through their control of the firm's governance structure. Such results are something of a quandary for classic agency theory, which treats agents (not principals) as the key source of inefficiencies in organizations where ownership and control are separated (Shapiro, 2005).

To more fully examine principals as a potential source of inefficiencies, we consider the case of entrepreneurial stage firms undergoing the IPO process. We observe that their heterogeneous interests give rise to principal–principal conflict that leads to forfeited gains in the form of ‘principal costs’. As with traditional agency costs, we suggest these principal costs represent inefficiencies that lead to suboptimal firm performance. Further, we develop propositions regarding principal costs in IPO firms. While principal costs exist in many firms, we expect them to be particularly prominent in firms undergoing IPOs. This is because the IPO process involves fundamental changes to the firm's governance and ownership structures. These changes influence the control over the organization and the ultimate payoff of many parties that have participated in the firm's development and potentially see the IPO as a chance to exit. In such an ‘end-game’ environment, we anticipate that many principals with heterogeneous interests will view the IPO process as a natural setting to exert influence to achieve their various goals.

We begin our paper by first discussing the IPO context and the attributes of this process which make it well-suited to the study of principal–principal conflict and governance. We discuss interest heterogeneity among principals and review and expand upon the agency logic surrounding principal–agent conflict and principal–principal conflict. We present a figure which explicates the ways in which principal–principal conflict may be a source of significant costs to the firm. Following this, we offer a number of propositions examining the effect of principals' divergent interests on IPO firm governance. We conclude with a discussion of the implications of our work for agency theory and for research into IPOs.

IPOS AND GOVERNANCE

  1. Top of page
  2. INTRODUCTION
  3. IPOS AND GOVERNANCE
  4. HETEROGENEOUS INTERESTS AMONG PRINCIPALS
  5. REVIEWING AND EXTENDING AGENCY THEORY
  6. HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS
  7. DISCUSSION AND CONCLUSION
  8. CONCLUSION
  9. ACKNOWLEDGEMENTS
  10. REFERENCES

The IPO represents a critical step in the firm's progress (Certo et al., 2007). By going public, firms are able to draw on a much larger base of potential investors, who can provide the resources needed for further expansion (Daily et al., 2005). IPOs also facilitate the exit of early investors (angels, VCs, and others), allowing them to diversify their holdings away from the firm (Daily et al., 2005). This turnover in the ownership of the firm allows VCs and other early investors to reinvest their capital in other early stage firms or to return it to their own investors. Thus, the IPO provides potential benefits to both the firm and its principals.

Along with the benefits, however, there are significant risks that accompany the IPO process (Beatty and Zajac, 1994; Dalziel et al., 2010). By their nature, IPO firms – even with the cash infusions associated with going public – have limited resources and high levels of uncertainty (Certo, 2003; Chen et al., 2008; Lester et al., 2006). IPO firms face three main liabilities, which have been identified in the literature: the liabilities of newness and smallness (Freeman et al., 1983; Singh et al., 1986; Stinchcombe, 1965), and the ‘liability of market newness’ which centres on the uncertainty surrounding whether the firm will be able to effectively handle the rigours associated with life as a publicly-traded entity (Certo, 2003).

Less noticed, but no less important, is the liability of principal substitution (Arthurs et al., 2008; cf. White et al., 2004). The IPO process results in dilution of existing ownership in favour of retail and institutional investors (Allcock and Filatotchev, 2010). As part of this, formerly powerful actors either exit the firm completely or have their influence seriously diminished. Such changes, while not necessarily unwelcome to the diminished principals (e.g. those who want to use the IPO as an exit strategy), often result in end-game moves designed to extract as much value from the firm as possible. For those principals who will continue to hold some level of equity in the firm, there can also be moves to consolidate decision-making control or other levers of power prior to the IPO. Such efforts to use the apparatus of the firm's governance for private benefit can harm other principals, give rise to conflict among principals, and prove to be a significant liability to the firm.

HETEROGENEOUS INTERESTS AMONG PRINCIPALS

  1. Top of page
  2. INTRODUCTION
  3. IPOS AND GOVERNANCE
  4. HETEROGENEOUS INTERESTS AMONG PRINCIPALS
  5. REVIEWING AND EXTENDING AGENCY THEORY
  6. HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS
  7. DISCUSSION AND CONCLUSION
  8. CONCLUSION
  9. ACKNOWLEDGEMENTS
  10. REFERENCES

Key to addressing such principal–principal conflict and the liability it creates is an understanding of the heterogeneous interests of principals (Connelly et al., 2010). There are numerous potential differences in the interests of principals even when they have ownership stakes in the same entrepreneurial firm. For example, principals commonly own different percentages of equity in the firm and their stake in the firm represents different proportions of their total investment portfolios. Consequently, the importance of exerting time, effort, and resources to control agents and influence the direction of the firm varies among principals, as they do not share equally in the benefits of such efforts. Since principals also vary in their risk preferences, their intentions of doing future business with the focal firm, their preferred investment holding periods, and their anticipated returns at the end of these time horizons (Black, 1992; Gilson and Kraakman, 1991; Manigart et al., 2002), there is significant potential for interest heterogeneity to incite conflict among principals. Compounding these issues, principals are also likely to vary in their investment opportunity sets, so where retaining or augmenting a stake in the firm may be optimal for one principal, divesting the stake may be best for another. Because decisions to sell stock can have wealth consequences for those that retain their stakes (McBain and Krause, 1989), what serves the interests of one principal may conflict with the interests of others.

When faced with such principal–principal conflict, self-interested principals seem likely to exert control to protect their own particular interests. They can exert control through various mechanisms including board membership and representation, covenants on securities, voting rights, institutional pressure, and other forms of investor activism (Amoako-Adu and Smith, 2001; Ryan and Schneider, 2002). Principals vary widely in their ability and motivation to utilize these mechanisms. The literature has examined the influence of several influential principals including pension fund managers, professional investment managers, and corporate investors. It refers to these principals using terms such as ‘institutional investors’, ‘pressure-sensitive’ and ‘pressure-resistant’ owners, and large and small ‘blockholders’, among others (Hoskisson et al., 2002; Johnson et al., 2010). So-called ‘early stage’ investors such as founders, family members, angel investors, and venture capitalists (Chahine et al., 2007; De Clercq and Dimov, 2008), and also IPO underwriters are most salient to our focus on IPO firms. In order to more fully understand the interests and potential influence of these powerful investors to shape the IPO firm's governance apparatus we rely upon and contribute to agency theory. We now describe in greater detail the foundational principles of agency theory and how the inclusion of heterogeneity of interests among owners (principals) extends the theory.

REVIEWING AND EXTENDING AGENCY THEORY

  1. Top of page
  2. INTRODUCTION
  3. IPOS AND GOVERNANCE
  4. HETEROGENEOUS INTERESTS AMONG PRINCIPALS
  5. REVIEWING AND EXTENDING AGENCY THEORY
  6. HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS
  7. DISCUSSION AND CONCLUSION
  8. CONCLUSION
  9. ACKNOWLEDGEMENTS
  10. REFERENCES

Agency theory is rooted in the work of Berle and Means (1932) on the rise of passive property. The theory assumes individuals are self-interested and boundedly rational and highlights the potential for conflict between principals and agents (Eisenhardt, 1989). A key feature of agency theory is its specification of the costs associated with principal–agent relationships, including: (1) the cost of controlling agents (i.e. bonding and monitoring costs); and (2) the cost of failing to control agents (i.e. residual losses) (Jensen and Meckling, 1976). Figure 1 depicts the relationships between these costs.

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Figure 1. The costs of principal–agent conflict. Note: Area G represents gains to principals from reducing residual losses. Area L shows losses that firms suffer when control is inappropriately high.

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Largely missing from classic agency theory is the discussion of the potential for costs to arise from conflicting interests among principals. In order to more fully understand the costs associated with such conflicts, we briefly review the costs and benefits associated with mitigating principal–agent conflict (see Figure 1) and then extend this classic agency theory foundation by specifying the costs and benefits associated with mitigating principal–principal conflict (see Figure 2).

image

Figure 2. The costs of principal–principal conflict. Note: With the move of Line B from B1 to B2, area G (from Figure 1) is broken into two regions – RG (realized gains) and FG (forfeited gains or gains which are lost due to principal–principal conflict).

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In Figure 1, the y-axis measures costs and the x-axis measures control (i.e. bonding and monitoring effort). Curve A represents marginal control costs. Marginal control costs are the additional costs incurred from incremental control. Marginal reductions in residual losses, depicted by curve B1, are the reduction in residual losses expected from additional control. Thus, curve A represents incremental costs, while curve B1 represents incremental benefits. Curves A and B1 intersect at point X. When control reaches CX, the marginal benefit of control equals or breaks even with the marginal cost of control.

To illustrate, consider the arbitrary point C0 shown in Figure 1, which is to the left of level of control CX. At this level, the benefit of an additional unit of control (shown in the figure as $benefit) is larger than the cost ($cost) associated with that same additional unit of control, so overall the principals are benefiting from control. At this level, there are also additional benefits that can be derived if more control is exerted, but it is important to note that the marginal costs associated with achieving these marginal benefits are higher. In other words, when control is very low, a principal who increases control (e.g. through additional monitoring) will be able to substantially reduce the risk of large losses associated with opportunistic agent behaviour. However, further increases in control ultimately yield smaller and smaller returns as remaining opportunism becomes increasingly trivial or difficult to obviate. Accordingly, the marginal benefits of control (i.e. the marginal reduction in residual losses depicted as curve B1) dwindle at the same time as the marginal costs of control (curve A) increase. From an agency perspective, the goal is to ensure that the benefits of control surpass the costs, yielding net gains to principals. Shaded area G represents these gains to principals that result as control reduces more costly residual losses.

If principals exert too much control, the firm enters the area to the right of point CX, where the marginal costs of control are higher than the marginal benefits and the firm begins to experience losses. Exerting too much control or ‘over-governance’ can occur in a variety of ways. For example, rigid checks and balances, excessive reporting requirements (see The Controller's Report (2004) and Manzi (2007) for criticisms of the Sarbanes–Oxley Act), over-monitoring of executive compensation (Tosi and Gomez-Mejia, 1994), and too many layers of supervision can constrain managerial behaviour in undesirable ways and impose costs on the organization that are far above the benefits to be obtained (Shapiro, 2005). Additionally, principals – who typically have less knowledge of the internal workings of the firm than agents – must frequently monitor using gross proxies of performance such as financial measures rather than strategic criteria or first-hand operational insights. As a result, when these principals ‘try to closely monitor managerial actions, they may inadvertently cause managers to pursue non-wealth-maximizing strategies’ (Lane et al., 1998, p. 560). Finally, over-governance can shift risk to managers in ways that are ultimately detrimental to firm performance (Hoskisson et al., 2009). Shaded area L depicts the losses firms suffer to the right of CX when control is inappropriately high.

Principal Costs

In addition to examining the costs associated with principal–agent conflict, it is also important to recognize the potential for principal–principal conflict (Young et al., 2008). This conflict results from the plurality of (competing) interests of shareholders and their varying abilities to exert control (Hoskisson et al., 2002). Villalonga and Amit (2006, p. 387) suggest it occurs because a ‘large shareholder may use its controlling position in the firm to extract private benefits at the expense of the small shareholders’. The logic is that when principals exert control they tend to favour their own interests over those of others.

Figure 2 depicts what happens as principals exert ‘biased control’. When a given principal uses its influence to bend the governance of the firm to its own benefit rather than focusing on the shared interests of all the firm's principals, it redirects the governance devices towards tasks that suit its own ends but which will be less useful in reducing residual losses. This is indicated by the lower marginal residual loss reduction curve (B2) shown in Figure 2. This results in a new equilibrium level of control indicated as CY.

By lowering the residual loss reduction curve, principal–principal conflict deprives the firm of some of the benefits of control. In effect, the gain area G is divided into two sections, such that G = RG + FG. The (actual or realized) gains, which are represented by area RG, are substantially smaller than G because worthwhile tasks are being neglected as powerful principals use governance mechanisms to pursue their own agendas. Potential gains which the firm could have enjoyed are forfeited as governance mechanisms are diverted away from their intended purpose. The region FG shows the size of these forfeited gains and is a measure of unrealized governance potential.

We formally define principal costs as the forfeited gains which result from principal–principal conflict and the associated neglect of important governance tasks. Principal costs have the effect of reducing the value of the firm below what it otherwise would have been. Principal costs can occur in a variety of ways. For example, suppose that a powerful principal with the desire to exit its investment soon after the IPO is pushing the firm to ‘window dress’ its financial results. This principal might leverage the board and top executives to rally the firm to engage in short-sighted cost cutting or to aggressively accelerate revenue recognition (DuCharme et al., 2004). As top executives focus more of their efforts on improving appearances and less attention on controlling actual results, the firm is likely to suffer declines in operating performance (Dalziel et al., 2010).

This can occur because drawing attention to a biased agenda can make the firm more prone to overlook agent opportunism in other areas. Developing the above example, when a powerful principal focuses on increasing short-run IPO stock performance, it may distract the firm away from pursuing important opportunities (e.g. strengthening operating controls that could set the stage for meaningful long-term improvements in efficiency or investing in worthwhile R&D, which could improve long-run performance). Given the need for principals to encourage risk-averse managers to pursue long-term investments in R&D and other areas (Wiseman and Gomez-Mejia, 1998), a powerful principal with a short-term outlook may cause the firm to miss out on some of the benefits of control, thereby producing principal costs.

In line with this illustration, Jain and Kini (1994) find significant declines in the operating performance of IPO firms in the post-IPO period, which they interpret as consistent with the idea that window dressing of financial statements is taking place prior to the IPO. This window dressing often occurs before the IPO (Teoh et al., 1998) in the form of earnings management behaviour (e.g. aggressively recognizing earnings) in an attempt to boost short-term valuation at the time of the IPO. However, this activity is associated with long-term declines in performance and stock valuation. It is our contention that, to the extent strong principals are abetting these earnings management practices rather than monitoring and incentivizing more substantive improvements, IPO firms are likely to incur principal costs.

Principal costs can arise for other reasons as well. A powerful principal might overlook inefficiencies to preserve the position of a family friend, revise a compensation plan to ingratiate themselves with a regional manager at the expense of other shareholders, or overlook its fiduciary duty by condoning excess expenses in order to benefit one of its outside business interests. In sum, when a powerful principal dominates the control of agents, it is likely it will promote its own personal interests. To the degree these interests deviate from those of other principals, principal costs can result. Having illustrated that principals can exert influence in ways that compete with the interests of other principals and lead to inefficiencies in the form of principal costs, we now apply this understanding to the IPO context.

HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS

  1. Top of page
  2. INTRODUCTION
  3. IPOS AND GOVERNANCE
  4. HETEROGENEOUS INTERESTS AMONG PRINCIPALS
  5. REVIEWING AND EXTENDING AGENCY THEORY
  6. HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS
  7. DISCUSSION AND CONCLUSION
  8. CONCLUSION
  9. ACKNOWLEDGEMENTS
  10. REFERENCES

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.

Table I.  Causes and effects of heterogeneous interests among principals
Principals Investment time horizon (at IPO) Importance of ownership stake in IPO firm Key loyalties Effects
Angel investorsShort-termMedium – while generally not as resource rich as VC firms or underwriters, angels often have stakes in many entrepreneurial companiesPrimary loyalty is to selfLoss of influence and dilution of stake (with the advent of other investors) motivates a quicker exit which may be associated with higher underpricing
Venture capitalistsShort-termLow – particularly for established VC firms that own stakes in many entrepreneurial companiesPrimary loyalty is to their own VC firm and its investorsHigher underpricing at IPO; potential for longer-term performance declines; negative abnormal returns at expiration of lockup period
UnderwritersShort-termLow – have stakes in many firms; more concerned with deal flow than the success of a single IPOPrimary loyalty is to their own firm, its owners, and syndicate partnersHigher underpricing at IPO
FamilyLong-termHigh – family identity is interwoven with firm controlPrimary loyalty is to the family; no obvious outside loyaltiesLimitations on ability to attract equity investors before the IPO; lower valuation at IPO
FoundersVariesHigh – personal identity and achievement are often associated with the firmNo obvious outside loyaltiesSimilar to problems plaguing family firms unless control is balanced; higher underpricing when there is less outsider representation on the board of directors

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.[1] 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.

Heterogeneous Loyalties

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.

DISCUSSION AND CONCLUSION

  1. Top of page
  2. INTRODUCTION
  3. IPOS AND GOVERNANCE
  4. HETEROGENEOUS INTERESTS AMONG PRINCIPALS
  5. REVIEWING AND EXTENDING AGENCY THEORY
  6. HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS
  7. DISCUSSION AND CONCLUSION
  8. CONCLUSION
  9. ACKNOWLEDGEMENTS
  10. REFERENCES

The IPO is an important area of inquiry for entrepreneurship scholars given the significant organizational changes occurring around the event and the long-term influence this event has on the life of the organization. Although much has been written about the impact of governance structures on the IPO process using an agency theory lens, more attention to the potential conflict among principals with heterogeneous interests is warranted. In fact, the full impact of this potential (principal–principal) conflict is often lacking in scholarly studies examining IPOs. We have sought to develop theory to explain the sources of principal–principal conflict and their impact on principal costs in IPO firms.

Contributions to Agency Theory

Our paper contributes to the agency literature in several ways. First, we more fully extend the agency assumption of self-interest to the firm's principals. In so doing we address a key limitation of agency theory. While agency theory assumes human nature is self-interested (Eisenhardt, 1989), the implications of this self-interest in principals have not been fully explored. Our work addresses this limitation by acknowledging that principals can create inefficiencies by seeking their own interests at the expense of others who have different preferences and interests.

Second, we discuss reasons for heterogeneous interests among principals in IPO firms. Figures 1 and 2 show how this heterogeneity of owner interests can lead to principal costs for the firm. This research is important as it provides insight into governance problems which transcend the typical agency problem associated with self-interest seeking by agents. By identifying principal-related governance problems and principal costs, we lay the groundwork for dialogue concerning the ways in which self-interested principals may co-opt the various governance mechanisms of the firm to their own advantage.

Finally, our work may be a step towards elucidating the reasons behind the weak empirical support of some key agency theory tenets. Classic agency theory logic suggests that empowering outside directors through having an outside director as board chair and a higher percentage of outside directors on the board improves performance by reducing agency costs. However, giving too much control to these outside directors and the principals they represent may allow them to pursue their own private interests and principal costs may result. Because principal costs represent inefficiencies, they may be counteracting the positive effects of board independence on firm performance. Thus, principal costs provide a useful explanation of why empirical research in IPO firms (e.g. Arthurs et al., 2008; Certo et al., 2001b) does not consistently corroborate the agency logic connecting outsider composition and separate board leadership structure to better performance.

Contributions to IPO Research

Our work also contributes to the literature on IPO research in important ways. For example, researchers find that firm performance is higher, both at the time of the offering and thereafter, when pre-IPO owners retain their stakes in the IPO firm. One explanation for this is that retained ownership sends a positive signal to the market, which enhances IPO performance (Bruton et al., 2009). Another is that founders who stay possess knowledge that helps the firm to pursue its vision (Kroll et al., 2007). Our work provides an alternative explanation. If important principals have strong exit preferences, they are likely to pursue their own short-term agendas without regard for the long-term success of the IPO firm, creating principal costs for those principals who retain their stakes in the IPO firm. On the other hand, in the absence of such heterogeneous investment horizons, we would expect principal costs to be lower and IPO performance to be higher.

Our research also identifies the potential impact that principals who place a high importance or psychological attachment on their equity stakes can have on an IPO-stage firm. In the context of research which finds that family firms can achieve long-term growth by undergoing IPOs (e.g. Mazzola and Marchisio, 2002), our work provides a cautionary tale to family members who oppose the IPO in view of maintaining control. It also provides an additional explanation of related research, which finds that when pre-IPO principals retain too much equity, IPO performance suffers (Bruton et al., 2009). As we argued earlier, an unwillingness of some pre-IPO principals to relinquish their hold on the firm may create principal costs, which dampen IPO performance.

This dampened performance can arise because of the excessive control exercised by a dominant family or a powerful founder. For example, because potential investors are likely to recognize the principal costs that they might bear after the IPO in such firms, they will require a discount to induce their investment. Furthermore, it is likely that other principals who could add value to the organization (such as experienced directors) may be less willing to adjoin themselves to the firm for similar reasons. Accordingly, the principal costs in this situation not only reduce the capital which can be raised (and the cost of raising it), but also reduce access to others who could help the organization perform better.

In addition to these contributions, our research suggests that principals whose loyalty lies with outside entities may seek to advance the interests of those entities, to the detriment of other principals. This insight could assist researchers in considering the effect of a wider array of variables in their predictions of IPO performance, including the affiliations and network ties of principals. Insofar as affiliations and network ties are more commonly studied using network and resource dependence theories, such an approach could provide complementary insights to agency theory based research on the governance of IPO-stage firms.

Principal costs may also provide a novel explanation of IPO underpricing (see Daily et al., 2003b, for other causes). When potential investors perceive that powerful principals are pursuing their own agendas, they may question whether their own interests will be fully safeguarded and are more likely to require a discount to induce investment. Thus, perceptions of potential conflict among principal interests seem likely to increase investor concern, leading to underpricing.

Extensions

Our work may be useful in opening new avenues for research. While we identified some important sources of principal–principal conflict, additional reasons for principal–principal conflict (e.g. preferences regarding specific strategies) could also be explored. For example, Hoskisson et al. (2002) found that pension and mutual fund managers had significantly different preferences for the amount of R&D taking place within the firm. Naturally, such differences can have long-run implications for the returns generated by the firm's principals. Accordingly, strategic preferences are likely sources of principal–principal conflict and may result in principal costs.

Additionally, empirical testing is needed to identify the financial ramifications of principal costs in IPO firms. As noted earlier, we expect that the existence of significant principal costs will create trading price discounts in the shares of equity for at least two reasons. First, principals whose interests are subordinated may seek to exit their investment (likely at a discount) when other forms of remedy are unavailable. Second, owing to lockup provisions, the market appears to recognize the problems implicit in principal investment horizon heterogeneity and therefore discounts a stock at the time when short-term investors can exit their investment (Bradley et al., 2001). Furthermore, as noted earlier, other potential investors may require a significant discount to induce their investment if they believe their interests may not be fully safeguarded.

One way to test our theorizing is to examine the dispersion of ownership among different principals in the IPO. We believe that as one principal group attains increasing power vis-à-vis other principals, the potential for principal costs will rise concomitantly. Therefore, we believe that it is useful to examine the current dispersion of ownership as well as the transfer of ownership in the IPO process. For this analysis, the Gini coefficient for dispersion of ownership may prove especially useful. While the Gini coefficient is often used to examine income disparity in a country (Clarke et al., 2003), it seems quite appropriate for use in the IPO context. We look forward to empirically testing the ideas in the paper and believe that the IPO setting will provide an ideal testing ground given the potential for principal–principal conflict to occur throughout the IPO process.

Finally, we recommend that scholars consider how best to overcome principal costs. We speculate that two governance structures commonly associated with higher levels of agent opportunism, inside directors and CEO–board chair duality, may be useful in reducing principal costs. Though principal costs have not been the subject of much study, there is some support for the idea that giving a greater degree of control to insiders can enhance IPO performance (e.g. Arthurs et al., 2008; Kroll et al., 2007). Insofar as these mechanisms give a greater measure of control to agents, they may simultaneously increase the risk of agency costs. Thus, configuring an array of governance mechanisms to provide checks and balances for both principals and agents seems important. While this suggestion diverges from classic agency theory which focuses on principal–agent conflict and agent opportunism, we suggest that principal–principal conflict also leads to inefficiencies that dampen the performance of IPO firms and warrants attention. For example, governance mechanisms could be configured to facilitate both top-down (principal–agent) and bottom-up (agent–principal) governance.

CONCLUSION

  1. Top of page
  2. INTRODUCTION
  3. IPOS AND GOVERNANCE
  4. HETEROGENEOUS INTERESTS AMONG PRINCIPALS
  5. REVIEWING AND EXTENDING AGENCY THEORY
  6. HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS
  7. DISCUSSION AND CONCLUSION
  8. CONCLUSION
  9. ACKNOWLEDGEMENTS
  10. REFERENCES

The IPO period is a time during which firm governance is particularly important. It is also a period when owners (principals) are particularly powerful and active. During the IPO period, principals' interests can differ sharply, leading to a strong degree of heterogeneity among principals. We explored the effects of heterogeneity of principals' interests on principal costs, which we defined as the forfeited gains which result from principal–principal conflict and the associated neglect of important governance tasks. Specifically, this study examined how heterogeneous investment time horizons among principals, heterogeneity in the importance of ownership among principals, and heterogeneity in principal loyalties may give rise to principal costs at the time of the IPO. We encourage further research into principal heterogeneity and the associated principal costs, both in the IPO setting and more broadly.

ACKNOWLEDGEMENTS

  1. Top of page
  2. INTRODUCTION
  3. IPOS AND GOVERNANCE
  4. HETEROGENEOUS INTERESTS AMONG PRINCIPALS
  5. REVIEWING AND EXTENDING AGENCY THEORY
  6. HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS
  7. DISCUSSION AND CONCLUSION
  8. CONCLUSION
  9. ACKNOWLEDGEMENTS
  10. REFERENCES

We would like to thank Richard A. Johnson, Robert E. Hoskisson, and two anonymous reviewers for their insightful comments, which helped us immensely in revising this manuscript.

NOTE
  • [1] 

    The response of Pam Thomas Faber, daughter of founder Dave Thomas, to the recent buy-out of the US-based Wendy's fast-food chain illustrates this issue. Said Faber, ‘It's a very sad day for Wendy's, and our family. We just didn't think this would be the outcome’ (Williams, 2008).

REFERENCES

  1. Top of page
  2. INTRODUCTION
  3. IPOS AND GOVERNANCE
  4. HETEROGENEOUS INTERESTS AMONG PRINCIPALS
  5. REVIEWING AND EXTENDING AGENCY THEORY
  6. HETEROGENEOUS INTERESTS AND PRINCIPAL COSTS IN IPO FIRMS
  7. DISCUSSION AND CONCLUSION
  8. CONCLUSION
  9. ACKNOWLEDGEMENTS
  10. REFERENCES
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