September, 2004

They Came, They Conquered, They Collapsed:

The Impact of NASDAQ’s Lowering of Listing Standards in 1997

April Klein Stern School of Business

New York University 44 W 4th St, Suite 10-92 New York, NY 10012 aklein@stern.nyu.edu

Partha S. Mohanram Columbia Business School

605-A Uris Hall, 3022 Broadway

New York, NY 10027 pm2128@columbia.edu

Abstract: In August 1997, the NASDAQ introduced a new listing standard based on market capitalization alone (Type 3), arguing that accounting regulations pertaining to goodwill for M&A and depreciation for telecom firms hindered many NASDAQ caliber firms from listing. In this paper, we ask three research questions. First, what impact did the new standard have on the composition of the NASDAQ? Second, was the NASDAQ’s rationale justified? Finally, how does the financial and return performance Type 3 firms compare with other new listings? We find that the new listing standard had a profound impact on the NASDAQ, as over 65% of new listings between Aug 1997 and June 2000 entered under the market capitalization standard. We also find that the NASDAQ’s rationale is weak as less than 5% of the Type 3 listings would have been able to list even if the negative effects of the accounting were adjusted. Finally, Type 3 firms perform far worse than other new listings both in terms of long-run stock returns as well as financial performance and display much greater return volatility. To summarize, the new standard allowed the entry of a large cohort of early stage, financially weak speculative firms that ultimately rose and fell with the NASDAQ bubble of the late 1990s. ________________________________________________________________________ We would like to thank Eugene Fama, Ken French and Jay Ritter for allowing us to use their datasets of new listings and internet IPOs.

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They Came, They Conquered, They Collapsed: The Impact of NASDAQ’s Lowering of Listing Standards in 1997

Much has been written on the precipitous rise and fall of the NASDAQ in the late 1990s.

One particular phenomenon that has been explored is the advent of a seemingly new cadre of

new listings on the NASDAQ National Market (NNM) during its boom period. Compared to

previous waves of new listings, most firms in the late 1990s came to market with large losses,

few revenues, and negative cash flows (Hand, 2000; Schultz and Zaman, 2001; Fama and

French, 2001). Upon listing, these firms exhibited extremely high underpricing premiums. Yet,

as Ritter and Welch (2002) show, the three-year raw returns for new listings were an

unprecedented –46.2% and -64.7% for stocks that went public in 1999 and 2000 respectively.

The poor financial characteristics of these new issues and the increased volatility over the

late 1990s have led to the conclusion that many of these firms came to market early (Schultz and

Zaman, 2001). Several papers have examined firms’ motivations for listing early and tried to

identify new pricing models to incorporate anomalous fundamentals – e.g. increased volatility

(Pástor and Veronesi, 2004) or investment expenses (Hand, 2000; Trueman et al., 2000).

One crucial unanswered question is why so many of these stocks came to market early.

Fama and French (2004) model the new listing market in supply and demand terms where firms

and the markets jointly determine supply, and investors determine demand. Under this view, the

recent surge of new listings with poor financials is consistent only with a downward shift in the

supply curve for new lists.1 Previous studies directly or indirectly acknowledge this economic

phenomenon, but treat it as exogenous. In this paper, we show that this is not the case. Instead,

1 An upward shift in demand would explain the deterioration in financial and market characteristics for new lists, but would result in a reduction in new listings, not an increase.

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we demonstrate that the spate of new NNM listings during the late 1990’s was, at least partially,

endogenously determined by the NASDAQ through a significant dilution in listing requirements.

Specifically, in August 1997, the NASDAQ revised its financial listing requirements by

introducing a third alternative, which we refer to as “Type 3” listing standards. Unlike the two

existing listing alternatives (henceforth called “Type 1” and “Type 2”), Type 3 new listings have

no minimum net income or tangible or intangible asset requirements, but instead, have a

minimum market capitalization requirement of $ 75 million.2 Alternatively, Type 3 firms could

list if they have minimums of both $75 million in revenues and total assets, but as we show, less

than 7% of the firms that newly-listed under this new standard met the revenues/total assets

hurdle.

We focus on three ramifications of the August 1997 listing standard change. First, did

the new listing standards significantly impact the overall makeup of the NASDAQ? Second, was

the rationale used by the NASDAQ in proposing the new standard justified? Finally, how do the

financial characteristics and performance of Type 3 firms compare with other new NNM

listings?

We find that between the initiation of the standard in August 1997 and the end of the tech

IPO boom in June 2000, 566 firms were newly listed under the Type 3 criteria. Without this

alternative, none of the 566 firms would have entered the NNM on their entry date. In contrast,

only 301 firms exceeded the financial thresholds for Type 1 or Type 2 new listings. Thus, over

65% of new listings over this time period were comprised of Type 3 firms. Further, at the end of

the first quarter of 2000, 10.3% of all traded NNM securities originated as Type 3 firms,

2 The Type 3 listing requirement should not be confused for “small market cap” requirements, which existed previously and were also changed in August 1997.

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representing 14.2% of the NNM’s total market capitalization. Thus, the new listing alternative

had a substantial effect on the overall make-up of the NNM.

Next, we examine the validity of NASDAQ’s stated rationale behind its introduction of

this new listing standard. The NASDAQ argued that a market capitalization listing standard

would allow the listing of companies that “would otherwise not qualify due to accounting

conventions associated with certain business combinations and specialized industries.”

(NASDAQ August 25, 1997 bulletin). Specifically, they claim that the accounting for goodwill

in purchase accounting for mergers and acquisitions, and the significant depreciation charges

incurred by telecommunications firms prevented “NNM caliber companies” from getting listed.

(NASDAQ 1996 bulletin). To assess the importance of these accounting distortions, we recast

goodwill as a tangible asset, eliminate all goodwill amortization from pretax income and rid

telecommunication firms’ pretax income of all depreciation expenses. After these accounting

adjustments, we find that only twenty-seven of the 566 Type 3 listings (4.8%) would have

qualified to list as Type 1 or Type 2 firms. We interpret this as evidence that accounting rules

did not prevent many Type 3 firms from listing otherwise on the NNM.

Third, we examine if Type 3 firms are similar to other NNM new listings. This is

important because the NASDAQ explicitly stated that companies entering under this new market

capitalization alternative would be “NASDAQ National Market caliber companies.” We find

unequivocal evidence to the contrary. Over a five-year event-time window, Type 3 firms earn

significantly less than other NNM new listings in terms of net income, operating income, and

operating cash flows. Long-run stock returns yield a similar conclusion - Type 3 firms perform

substantially worse than other NNM listings. After three years, Type 3 firms have a cumulative

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raw buy-and-hold return of -32.3%, compared with -5.8% for other NNM listings. Finally, Type

3 firms are significantly more volatile than other NNM firms and the NASDAQ index.

Our findings provide strong evidence that the market capitalization standard instituted in

1997 allowed a large group of early stage, risky, poor-performing firms to enter the NNM. Most

importantly, our results question the NASDAQ’s contention that the market capitalization listing

rule resulted in “NNM caliber” companies. Instead, we interpret the institution of the market

capitalization alternative as a relaxation of listing standards by the NASDAQ.

Our analysis proceeds as follows. In Section I, we present a historical overview of

NASDAQ listing standards from 1981 to 1997, including the change in the NNM listing standard

instituted by the NASDAQ in August 1997. Section II describes our sample selection and data.

We examine the first research question, the effect of the new Type 3 listing on the composition

of the NNNM, in Section III. In Section IV, we explore the second research question, the

NASDAQ’s justification for introducing a market capitalization listing standard, by looking at

the implications of accounting for goodwill and depreciation. Sections V through VIII examine

the third research question, whether Type 3 firms are fundamentally different than Type 1 or

Type 2 new listings. Section V compares financial characteristics on the listing date and Section

VI examines financial characteristics over time. In Section VII, we compare long-run stock

performances between Type 3 and other new listings. In Section VIII, we examine stock return

volatilities over time. Section IX summarizes and concludes.

I. A Historical Overview of NASDAQ Listing Standards

Stock markets impose listing standards on new and continuing firms to ensure a level of

“quality and protection for investors” (NASDAQ 1996). A firm that initially fails to meet the

market’s initial listing standards is denied admission, while a currently traded firm that falls

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below the market’s continuing requirements can and will be delisted eventually. These standards

include quantitative financial thresholds for earnings, cash flows, revenues, or net assets, as well

as qualitative governance requirements related to director and audit committee independence.

A. NASDAQ Listing Standards from Inception until 1997

The advent of multi-tiered initial listing standards for NASDAQ stocks arose in August,

1981 when the SEC allowed the NASDAQ to designate some of its listed firms as national

market system securities as of April 1982 on a experimental basis.3 In the first tier, the

NASDAQ designated approximately 40 currently-traded securities as NNM firms. In the second

tier, over 400 firms were eligible to be designated NNM firms if they voluntarily elected to do

so. Accordingly, the NASDAQ set up three sets of initial listing standards. Tier 1 set criteria for

mandatory inclusion into the NNM. Tier 2 set criteria for voluntary inclusion into the NNM,

with identical financial standards, but different trading parameters such as minimum bid price,

average trading volume, market value of public float and the number of outstanding shares

available for trading. Tier 3 consisted of Non-NNM firms that could be admitted to the

NASDAQ under lower minimum financial standards and no minimum trading parameters.

In 1984, the SEC allowed the NASDAQ to adopt a new set of criteria for Tier 1 and Tier

2 firms that allowed a far larger group of NASDAQ firms to attain national market status.4

Accordingly, the NASDAQ split Tier 2 into two alternatives, Alternative 1 and Alternative 2.

Alternative 1 introduced a minimum net income standard. Alternative 2 eschewed income

requirements, but imposed a minimum operating history requirement and significantly increased

the capital & surplus requirement. The Tier 2 changes became effective in January 1985, and

3 See SEC Release No. 34-17549, February 17, 1981. 4 See SEC Release No. 34-21583, December 18, 1984.

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around two hundred firms were added a month to the NNM until all eligible securities seeking

NNM designation were included.

In August 1987, the NASDAQ eliminated the mandatory NNM Tier 1 standard and

settled into two alternative initial NNM listing standards and one non-NNM listing standard.

Between 1987 and 1991, the standards were periodically strengthened by raising the quantitative

standards, constituting minimum pre-tax income standards for alternative 1 listings and

instituting corporate governance requirements for NNM firms.

In August 1991, the NASDAQ officially separated its markets into two tiers, the NNM and

the Small Cap Market (SCM). The SCM’s financial listing standards were raised and all

NASDAQ firms were subject to the same corporate governance rules. However, the financial

requirements for the two NNM alternatives were unaltered.

B. NASDAQ Listing Standards: The Change in 1997

In August 1997, the NASDAQ changed its NNM initial listing requirements in two ways.

First, it strengthened the financial requirements for alternatives 1 and 2. Second, it instituted a

third alternative, based not on financial characteristics, but instead deemed as a market

capitalization alternative. Table I provides the minimum financial standards for alternative

initial listing standards for the NNM prior to and after August 22, 1997. Panel A presents the

pre-1997 standards and Panel B contains the revised standards. Under the pre-1997 standards,

firms could list on the NNM under two separate criteria. Type 1 firms could list if they had at

(1) least $4 million of net tangible assets (total assets minus goodwill minus total liabilities) and

(2) net income of at least $400,000 in the firm’s last fiscal year or two of the last three fiscal

years. Type 2 firms could list if they had at least $12 million of net tangible assets, without any

minimum income requirement.

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Under the revised standards, Type 1 initial listings had to satisfy an increased net tangible

assets hurdle of $6 million. The income standard changed too; newly-listed Type 1 firms needed

at least $1 million pretax income in the last fiscal year or two of the last three fiscal years. The

Type 2 net tangible assets standard increased from $12 million to $18 million.

The most significant change, however, was the inclusion of a third listing standard, Type

3. Under this standard, newly-listed firms needed neither tangible assets nor positive pretax

income. Instead, firms could now list if they satisfied one of two requirements: (1) a minimum

market capitalization of $75 million, or (2) a minimum total asset base of $75 million and a

minimum of $75 million in revenues. As we show in the next section, the vast majority of Type

3 listings satisfied the market capitalization requirement only. Thus, a new group of firms

entered the NNM − firms with relatively few assets, little revenues, and negative income.

II. Sample Selection and Data Description

The data consist of all new listings on the NASDAQ National Market Index between

August 22, 1997 and June 30, 2000. August 22, 1997 coincides with the new listing

requirements. We end at June 30, 2000 as this approximately concurs with the end of the

NASDAQ bull market and the associated hot IPO market, and also gives us a window of time to

evaluate the effect of the new listings on the subsequent decline of the NASDAQ.

Our goal is to examine the full sample of newly-listed, non-financial NNM firms between

August 22, 1997 and June 30, 2000. As Panel A of Table II shows, we begin by identifying

1,541 NASDAQ firms that first appear between these dates on the files of the Center for

Research in Security Prices (CRSP). We eliminate 260 financial firms (SIC codes between 6000

and 6999), 89 firms with unit offerings (e.g., stock offerings combined with warrants) or reverse

LBOs, spin-offs, or secondary offerings, 168 firms that do not have a share code of 10 or 11

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(ordinary common shares), and 62 firms that are listed on other exchanges or are tracking stocks.

We augment our sample by adding 158 additional IPOs not in our sample from Fama and French

(2004) that satisfy the criteria listed above.5 Finally, we eliminate 253 firms that did not meet any

of the NASDAQ listing requirements for Type 1 – 3 firms.6 In total, we have 867 new listings.

To verify our sample of initial listings, we compare our sample to two IPO sources - the

Thomson SDC Database and the sample of IPOs used by Fama and French (2004). As we show

in Panel B of Table II, 549 firms in our final sample appear on both these databases. We include

99 firms appearing on Thomson SDC but not in Fama and French’s sample, as well as 102 firms

not on Thomson SDC but in Fama and French’s database. Finally, we include 117 firms that

satisfy the criteria laid out in Panel A but do not appear in either the Thomson SDC or the Fama

and French (2004) database. In total, we have 867 new listings.

We classify new listings into the three types: Type 1, Type 2, and Type 3, using financial

information prior to the new listing date, obtained from COMPUSTAT. Since the NASDAQ

does not classify a new listing by type on the original listing date, or subsequently, we use the

financial criteria as published by the NASDAQ to infer the listing type. Our classification is

done sequentially using financial information from the fiscal year end just prior to the listing. If

a firm has net tangible assets of at least $6 million and pretax income of at least $1 million, we

call it a Type 1 firm. If a firm does not satisfy these requirements, but has at least $18 million of

net tangible assets, we classify it as a Type 2 firm. If the firm does not satisfy the Type 1 or

5 The Fama and French (2004) database comes from three sources: the Thomson SDC Data, which we use, Loughran and Ritter (1995) and Eckbo and Norli (2002). 6 We examine the financial characteristics of these 253 firms. The average firm has $41.6 million in assets, and $23.7 million in revenues. The assets number is almost one-fifth of the assets for the average Type 3 firms and less than one-tenth of the assets for the average Type 1 or Type 2 firm. The revenues number is about one-fourth of the revenues for the average Type 3 firm and between one-eight and one-fifteenth of the size of the average Type 1 or Type 2 firm, respectively. These firms most likely are small-cap firms, which we do not analyze in this paper.

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Type 2 requirements, but has at least $75 million in both total assets and revenues, or a market

capitalization of $75 million, this firm is designated a Type 3 firm.

III. Effect of New Listing Requirements on the Composition of New Listings

Our first research question looks at the effect of the new Type 3 listing requirements on the

composition of the NASDAQ. Specifically, we examine what proportion of new listings are

classified as Type 3, how this proportion changes over time, how the industry composition of

Type 3 listings differ from other new NNM listings, and what proportion of the NASDAQ

consists of firms that debuted as Type 3 listings.

A. New Listings by Type

In Table III Panel A, we compare the distribution of Type 1, 2 and 3 new listings over the

sample period. Over 65% of new listings are Type 3. In contrast, only 21.0% of the new lists

are Type 1, and 13.7% of the new lists are Type 2. Thus, Type 3 listings dominate the firms

entering the NNM from August 1997 through June 2000.

Type 3 stocks have to meet one of two criteria: minimum of $75 million in market

capitalization, or minimum of $75 million of both total assets and revenues. As Panel B of Table

III shows, almost every Type 3 new listing (97.9%) had a market capitalization of at least $75

million. The vast majority of firms, 529 firms (93.5% of all Type 3 listings), satisfied the market

capitalization criterion alone. In contrast, only 37 Type 3 firms (6.5%) exceeded the $75 million

revenues and assets listing hurdle. Of these firms, 12 firms (2.1% of all Type 3 listings) entered

the NNM by satisfying the revenues and assets criteria, but not the market capitalization

criterion. Thus, the total revenues/total assets criterion yielded few Type 3 firms.

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B. New Listings over Time

In Table III, Panel C, we present new listings by quarter. Concurrent with the NASDAQ

index, which rose from 1499 in August 1998 to 4697 in February 2000, we notice a new listings

boom during this period. The year 1999, in particular, produced 382 new listings, an increase of

108% over 1998. Most significant, however, was the proliferation of Type 3 listings during 1999

- 285 listings compared to only 105 in 1998. We particularly note the shift away from Type 1

listings towards Type 3 listings during the last three quarters of 1999. Thus, the boom market of

1998 – 1999 is strongly associated with a new class of firms listing under the NNM banner.

C. New Listings by Industry

Table IV compares the industry composition of Type 3 listings and other listings, where

industry is defined as the firm’s primary three-digit SIC code. The plurality of new listings for

both set of firms falls under the three-digit SIC code, 737 – Computer and Data Processing

Services. For Type 3 listings, there are 211 computer and data processing firms, encompassing

37.3% of all Type 3 listings. In contrast, fifty-nine (19.6%) of Type 1 or 2 new listings are in

that industry. Using Field and Hanka’s (2000) classification of high technology firms, we find

that 269 Type 3 listings (47.5%) can be classified as high-tech, but that only 91 Type 1 and 2

firms (30.2%) fall into their hi-tech category.7 Using Francis and Schipper’s (1999) broader

definition of hi-tech stocks, 346 Type 3 new listings (61.1%) and 127 other NNM new listings

7 Following Field and Hanka (2000), all firms with primary three-digit SIC codes in computer and office equipment (357), electronic components and accessories (367), miscellaneous electrical machinery equipment and supplies (369), measuring and controlling devices (382), medical instrument and supplies (384), and computer and data processing services (737) are categorized as hi-tech firms.

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(42.2%) are hi-tech.8 Thus, the high-tech new listing boom of the late 1990’s documented in the

finance literature is primarily an outgrowth of the introduction of the Type 3 listing criterion.

In Panel B of Table IV, we present the distribution of the 424 internet IPOs that debuted

between August 22, 1997 and June 30, 2000, as per Ritter’s internet IPO database. Over 50% of

all internet IPOs over that period (213 listings) entered the marketplace under the Type 3

umbrella. In contrast, only 13% of internet IPOs (55) were Type 1 or Type 2 NNM listings. Put

differently, the 213 Type 3 internet listings represent 37.6% of all Type 3 listings, while the 55

non-type 3 internet listings comprise only 18.3% of Type 1 or 2 new listings.

D. Type 3 Listings as a Percentage of the Total NNM

In Table V, we present Type 3 firms as a proportion of all NNM-traded companies over

time from fourth quarter 1997 through fourth quarter 2003, both in number and market

capitalization. We find that the percentage of Type 3 firms rises steadily from 0.8% of the total

number of all NNM-traded firms in 1997-Q4 to 10.4% in 2000-Q3. Afterwards, we note a

steady deterioration in proportions to 7.8% in 2003-Q4. This coincides with the rise and fall in

the absolute number of Type 3 stocks trading on the NNM over this time period. One statistic

worth noting is that from 2000-Q2, the height of the NASDAQ bubble, through 2001-Q1, more

than one in ten NNM stocks originated as a Type 3 new listing.

As the right-hand side of Table V demonstrates, Type 3 firms comprise just 0.6% of the

total market capitalization of the NNM in 1997-Q4. By 2000-Q1, just before the bursting of the

NASDAQ bubble, Type 3 firms represent 14.2% of total market capitalization. In dollars, we

find an increase of 82% ($883.3 billion vs. $485.5 billion) in market capitalization between

8 Francis and Schipper’s (1999) hi-tech classification encompass all firms with primary three-digit SIC codes in drugs (283), computer and office equipment (357), electronics and other electrical equipment (360-368), telephone communications (481), computer and data processing services (737), and research, development, testing services (873).

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1999-Q4 and 2000-Q1 alone. By 2003-Q4, Type 3 firms represent only 5.0% of the total NNM

market capitalization. Note that the rise and fall of the proportion of Type 3 firms is much more

pronounced when measured in market capitalization than in number of trading firms. As we

later demonstrate, this is directly related to the market performances of Type 3 firms, which

show dramatic increases and decreases, when compared to other listing types.

IV. Are the NASDAQ’s Stated Reasons for Type 3 Listings Valid?

The NASDAQ offered the following reason when announcing the adoption of the market

capitalization alternative (NASDAQ Bulletin, August 25, 1997)

The adoption of a market capitalization test will help foster capital formation for NASDAQ National Market caliber companies that would otherwise not qualify due to accounting conventions associated with certain business combinations and specialized industries under the heading ‘Initial Listing 3’. This follows a notice to NASD members (November 1996) which stated

Consistent with the reputation of NASDAQ for facilitating capital formation for growth companies, it was determined that there was a need for an accommodation for companies that may fail to comply with the National Market net tangible asset test as a result of accounting for goodwill associated with various merger and acquisition activities, or as in the case of the telecommunications industry, significant depreciation charges. The suggested changes provide access for NASDAQ National Market caliber companies that could otherwise not qualify due to accounting conventions associated with certain business combinations and specialized industries Goodwill is an intangible asset that arises when a company accounts for the acquisition of

another company under the purchase method of accounting. Thus, goodwill is not part of the net

tangible assets criterion for Type 1 or 2 listings. Further, goodwill is amortized over a period not

exceeding forty years, reducing the firm’s pretax income, another criterion for Type 1 listing.9

We interpret NASDAQ’s statements about goodwill/business combinations as an assertion that if

9 Starting July 1, 2001, SFAS No. 141 requires all mergers and acquisitions to be treated as a purchase. Prior to this, firms could also use pooling-of-interests accounting, which yield no goodwill. Further, beginning July 1, 2001 SFAS No. 142 eliminates the expensing of goodwill. Instead, firms perform an impairment test on goodwill and mark it down with a one time expense if its fair market value is less than its book value.

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goodwill were treated as a tangible asset instead of an intangible asset, then many Type 3 firms

would have qualified for admission to the NNM as either Type 1 or Type 2 firms. Similarly, we

interpret the NASDAQ’s statement on excessive depreciation charges in telecommunications

(henceforth telecom) firms as implying that with lower depreciation, these firms would have

been able to enter the NNM as either Type 1 or Type 2 firms. We now examine these assertions.

A. Effect of Goodwill Accounting on Listing Requirements

In Panel A of Table VI, we compare the composition of tangible and intangible assets for

Type 3 and other NNM new lists at the time of listing. Type 3 firms have significantly fewer

mean net tangible assets (1.7 million vs. 111.7 million for Type 1 or 2 listings). Not only is the

difference significantly different at the 1% level (t-stat -3.88), but the 1.7 million average falls

far short of the 6 million needed for Type 1 listings or the 18 million required for Type 2 listings.

However, relative to their asset base, Type 3 firms have significantly higher goodwill

than other NNM listings. Type 3 listings have, on average, 3.3% of goodwill/assets as against

1.5% for other listings, a significant difference at the 1% level (t-stat 3.23). Goodwill is 9.3% of

net assets (assets minus liabilities) for Type 3 listings as compared to 3.9% for other NNM

listings, a significant difference at the 5% level (t-stat 2.16). Thus, prima facie, the NASDAQ’s

contention that Type 3 firms are disadvantaged by higher goodwill has some merit.

To test this contention, we determine the number of Type 3 firms that were unable to list

as Type 1 or Type 2 firms because of goodwill accounting. We do this by making two pro-forma

accounting adjustments. First, we treat goodwill as if it were a tangible asset by adding it back to

net tangible assets. Second, we add back all amortization expenses to pre-tax income. Note that

this overstates the impact of goodwill amortization, as amortization expenses includes amortizing

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of other intangibles such as patents and franchises. We then use these pro forma numbers to

count how many firms Type 3 firms would have met the Type 1 or Type 2 thresholds.

Table VI, Panel B contains the results of this exercise. Of the 566 Type 3 firms, 16 firms

would have qualified as Type 1 firms and 7 additional firms would have qualified as Type 2

firms if the pro-forma adjusted net tangible assets and pre-tax income had been used. Thus, only

23 out of 566 Type 3 listings (4.1%) were penalized by goodwill accounting, while 543 firms, or

95.9% of the Type 3 listings still would have been unable to enter the NNM even if goodwill was

(1) treated as a tangible asset and (2) not amortized. Thus, the NASDAQ’s assertion that

accounting for goodwill prevented “NASDAQ caliber” firms from listing on the NNM has little

merit.

B. Effect of Depreciation on Telecommunications Firms

In Table VII, we perform a similar analysis for the effects of depreciation expense on

telecom new listings. In Panel A, we compare all telecom new listings with all non-telecom new

listings. We first note that ten percent (87 of 867) total new listings for our sample were in

telecom. As Panel A shows, telecom new listings do not differ significantly from non-telecom

new listings in terms of total dollar depreciation expense, accumulated depreciation or tangible

assets. Telecom new listings have significantly lower revenues and pretax income, but greater

total assets than non-telecoms. Telecom new listings have substantially higher depreciation

expense/revenues than non-telecoms in the listing year. The average depreciation

expense/revenues for telecoms is 23.2% percent against 9.9% percent for non-telecoms,

significantly different at the 1% level (t-stat of 4.81). However, depreciation expense/assets is

insignificantly different between telecoms (5%) and non-telecoms (5.4%).

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In Panel B, we compare Type 3 telecom new listings to Type 1 or Type 2 telecom new

listings. Of the 87 telecom new listings, 60 were Type 3 firms, with the remaining 27 telecoms

entering the NNM as Type 1 or Type 2 listings. In dollar terms, Type 3 telecoms have

significantly less depreciation expense, accumulated depreciation, revenues and total assets, but

similar tangible assets and pre-tax income as Type 1 or Type 2 telecom firms. The evidence on

relative depreciation expense is mixed. The average depreciation expense/revenues of 21.6% for

Type 3 telecoms is insignificantly different from the 25.8% average for other telecom listings.

However, the average depreciation expense/assets for Type 3 telecoms at 5.6%, is significantly

higher than the 3.6% average for other telecom listings.

In Panel C, we examine the degree that depreciation deterred the 60 Type 3 telecoms

from listing as Type 1 or Type 2 firms by reversing the accounting effects of depreciation.

Specifically, we add back all depreciation expenses for the listing year to pre-tax income. We

also add back all accumulated depreciation to net tangible assets to compute a pro forma “net

tangible assets” as if property, plant and equipment for Type 3 telecom firms were never

depreciated. We use these pro forma numbers to count how many of these firms would have

been able to list as Type 1 or Type 2 firms.

As Panel C shows, only 4 out of the 60 (6.7%) Type 3 telecoms would have been able to

enter the NNM as Type 1 or Type 2 firms if they had zero depreciation over time on their assets.

These four firms represent less than one percent of the 566 Type 3 firms that listed over our time

period. Thus, we conclude that accounting for depreciation did not have a major deleterious

effect on telecom firms entering the NNM under a net tangible and/or pretax income standard.

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V. Financial Characteristics of New NNM Listings by Type: Listing Date

In this section, we examine whether Type 3 new listings have similar financial

characteristics as other NNM new listings at the time of listing. If, as the NASDAQ contends,

Type 3 listings are of the same caliber as other NNM listings, there should be no systematic

differences between both groups.

We focus on the following financial characteristics: total assets, growth in assets,

revenues, growth in revenues, net income before extraordinary items, operating income (EBDIT)

and cash flows from operations (CFO).10 We use annual Compustat data for the year closest to

and prior to the listing date. In Table VIII, Panel A we compare means between Type 3 and a

pooled sample of Type 1 and 2 new listings. In Panel B we compare medians between the two

groups. The null hypothesis is no significant differences between means or medians.

A. Firm Size

Upon listing, Type 3 firms have significantly fewer assets and revenues than other NNM

new listings. The mean total assets for Type 3 firms is 78.5 million, compared to the mean total

assets of 285.4 million for other NNM listings, significantly different at 1% (t-stat -3.12). Type 3

new listings have a mean of 56.8 million in revenues; other NNM listings have average revenues

of 265.5 million, significantly different at the 5% level (t-stat -2.43). Similar significant

differences are seen in medians as well. Thus, the new Type 3 listing requirement allowed a

cohort of smaller firms to enter the NNM trading market.

The significant differences in size reflect the following factors. First, despite the fact that

Type 3 firms could enter the NNM under a total assets and revenues requirement of 75 million

apiece, the vast majority of Type 3 firms entered under the 75 million market capitalization route

10 The Compustat data items we use are Assets (#6), Revenues (#12), Net Income before extraordinary items (#18), Operating Income (#13), and Cash flows from operations (#308).

17

and have much lower total assets and revenues. Second, one reason cited by the NASDAQ for

instituting Type 3 listings is that many “NNM caliber” firms have substantial goodwill that

reduces net tangible assets and prevents them from listing. Total assets includes goodwill,

putting all firms on an equal footing. Yet, despite this, Type 3 firms are still substantially smaller

than other NNM listings.

B. Profitability

Consistent with the NNM listing requirements that only Type 1 firms have a minimum

positive pretax income threshold, we find that non-Type 3 listings have a positive average

nominal operating income (OI) of 29.6 million on the fiscal year end preceding the listing date,

whereas Type 3 listings have a negative average nominal operating income of -0.3 million,

significantly different at the 5% level (t-stat 1.98). The results on net income (NI) are mixed.

Median NI is -6.2 million for Type 3 firms, and 1.7 million for other listings, significantly

different at the 1% level (z-statistic -7.76). However, mean net income is insignificantly different

across the groups, -10.7 million for Type 3 vs. -4.2 million for other listings (t-stat -0.89).

To normalize income to firm size and to allow comparisons between our findings and

Fama and French (2001, 2004), we present profitability scaled by total assets. In Panel A, the

average OI/Assets is -50.0% for Type 3 listings, but is 2.2% percent for other NNM listings,

significantly different at the 1% level (t-stat -14.10). The average NI/Assets is -64.5% for Type 3

listings, compared to -6.4% for other NNM listings, again significantly different at the 1% level

(t-stat -14.26). Panel B produces a very similar pattern of differences for the medians. Thus, in

relative terms, Type 3 listings are significantly less profitable than its counterparts on the NNM.

18

Our results dovetail with Fama and French (2001), who show a deterioration of

profitability over time for new lists.11 Fama and French (2001) report a dramatic decline in

average EBIT/Assets from 6.7% for 1988 - 1992 to 3.7% for 1993 - 1998. Our results indicate

that the deterioration of earnings for new lists in the listing year continues after 1998, the end of

the Fama and French (2001) sample. As seen above, much of this decline comes from the

addition of the Type 3 listings.

In Panel A, we also present the proportion of firms that report losses (negative NI) at the

time of listing. For our sample, 39.9% percent of non-type 3 firms report losses compared to

81.1% of Type 3 firms, significantly different at the 1% level. To put these percentages in

perspective, we compare them to several studies. Klein and Marquardt (2004) report that in

1997-2000, 38.8% of all firms listed on the Compustat database have losses. Hence, Type 3

firms clearly hail from the left tail of earnings distributions, while other NNM new lists are

similar to Compustat firms. Ritter and Welch (2002) find that the proportion of new listings

reporting losses rises from 37% in 1995-1998 to 79% in 1999-2000 and then declines to 49% in

2001. Since the majority of Type 3 firms are listed in 1999 and 2000, we offer a possible

explanation for this blip upwards in proportion of losses during this two year period.12

C. Cash Flows from Operations

Like earnings, operating cash flows (CFO), on average, are negative for Type 3 firms.

The mean CFO for Type 3 new listings is -1.3 million, as opposed to 17.8 million for other NNM

listings, significantly different at the 10% level (t-stat -1.87). Mean CFO/Assets for Type 3 firms

11 Although their samples contain NYSE, AMEX, and NASDAQ firms, Fama and French (2001) find that 85% of new lists between 1978 and 1998 originate on the NASDAQ, and that 90% of the new lists in their sample for 1973-2000 are on the NASDAQ (Fama and French, 2004). 12 Ritter and Welch (2002) also report that the proportion of losses in IPOs was 19% in 1980-1989 and 26% in 1990-1994.

19

is -37.9%, as against -0.5% for other NNM listings, significantly different at the 1% level (t-stat -

13.61). Further, while 40.9% of other listings report negative CFOs, over three-quarters of Type

3 listings (76.5%) have negative CFOs. The medians show a similar pattern of differences.

In tandem, the earnings and cash flow findings paint a bleak picture about the

profitability and liquidity of Type 3 listings. Clearly, the new listing requirements introduced a

class of equities that were very poor performers just prior to their offering dates.

D. Asset and Revenues Growth Rates

Fama and French (2004) demonstrate that although new lists in the 1990’s were relatively

unprofitable, they nevertheless displayed huge growth in assets (average annual growth rate of

66.8% in 1990-2000). Fama and French (2004) report this number for the fiscal year that

includes the listing month. We report asset growth rates for the year prior to the listing date. For

our sample of new listings, we report mean one-year asset growth rates of 218.3% for Type 3

firms and 237.5% for other NNM listings. The medians are lower, 105.4% for Type 3 new

listings and 67.1% for Type 3 new listings. We find no difference in means or medians between

Type 3 and other NNM asset growth rates. Nevertheless, it is clear from Table VIII that Type 3

firms experience huge asset growth rates in the year prior to their inclusion on the NNM.

Another interesting observation is that we have two years of data for only 295 of the 566 (52%)

Type 3 firms as opposed to 235 of the 301 (78%) non-type 3 firms. This is a direct result of

many more Type 3 firms going public with less than two years of operating history.

We observe high one-year growth rates on revenues for both Type 3 and other NNM

listings. The average one-year revenues growth rate for Type 3 new listings is 231.1% percent,

compared to a 178.2% for other listings. The medians are 96.4% for Type 3 firms and 45.6% for

other NNM listings. Unlike asset growth, these means and medians are significantly different

20

from each other (at 10% level for means, t-stat 1.88 and 1% level for medians, z-statistic 3.08).

Thus, Type 3 firms have higher revenue growth rates than other NNM listings.

VI. Financial Characteristics of New Listings by Type: Five Years After Listing

We examine the financial characteristics of new listings by type for the five years

following the listing. We present our results in event time, where year 1 is the year including the

listing month and years 2 through 5 are the subsequent four years.13 Table IX presents the

medians of the following five metrics: net income/assets (NI/Assets), operating income/assets

(OI/Assets), CFO/assets, asset growth (AGR), and revenues growth (RGR).14 We present results

for all new listings, as well as for Type 3 and other NNM listings.

Net income is negative for all new listings for years 1 through 5. Median NI/Assets is

-8.9% in year 1, falls to -16.2% in year 3 and recovers to -4.7% percent in year 5. However,

when we divide our sample into Type 3 and non-Type 3 firms, a sharper image emerges. Type 3

firms experience negative earnings in all years, while other NNM listings have positive earnings

in years 1, 2, and 5. In fact, the pattern of net income for other NNM listings resembles closely

those reported by Fama and French (2004).15 Most significantly, Type 3 firms have significantly

lower NI/Assets than other NNM listings for each year, 1-5. Thus, the difference in profitability

between Type 3 and other listings is substantial and persistent over time.

This differential is even more dramatic for operating income and cash flows. For all five

years, OI/Assets is negative for Type 3 firms, but is positive for Type 1 or 2 listings. The

13 Similar results are obtained if we perform our analysis in calendar time from 1997-2002. Type 3 firms do substantially worse than other listings in each year due to both the entry of progressively weaker firms as well as the poor performance of firms after listings. Type 3 firms do display greater asset and revenue growth in 1997-1999, but this becomes insignificant in 2000 and reverses from 2001 onwards as they experience negative growth rates. 14 Very similar results are obtained with means instead of medians. 15 Fama and French (2004) report average net income/assets of 3.1%, 0.2%, -1.4%, -1.4%, and 0.8%, for years 1-5 respectively.

21

difference between groups is significant at the 1% level each year. Further, while other NNM

firms maintain stable positive operating income over time, Type 3 listings show extremely

negative operating income in years 1-3, improving to -0.8% in year 5 through survivorship.

Cash flows display a similar pattern. CFO/Assets for Type 3 firms is negative for years

1-4, while it is positive for Type 1 or 2 firms throughout the five year period. Thus, we

conclude that Type 3 firms are significantly less profitable in terms of earnings and cash flows

than other NNM listings over their initial trading life cycle.

Asset (AGR) and revenue growth (RGR) ratios produce an interesting picture. Assets

grow rapidly for both groups in year 1: 433.8% for Type 3 listings and 103.1% for other listings,

significantly different at the 1% level (z-statistic 12.43). However, asset growth halts

immediately after year 1 for both groups (11.4% for Type 3 and 12.3% for other listings),

indicating that the initial growth may be related to the infusion of funds from the IPO. As firms

move throughout time, they display a shrinking of assets. In years 3-5, the asset growth rates for

Type 3 firms are negative; for other NNM firms, they are negative in years 4 and 5. Further,

while Type 3 firms grow significantly more than other NNM in year 1, they deteriorate more

significantly in years 3-5.

Revenue growth rates have similar time patterns. Both groups show initial surges in

revenue; 124.2% and 78.1% for Type 3 firms in years 1 and 2 respectively, and 55.3% and

26.8% for other listings. In years 3-5, these growth rates diminish dramatically, with Type 3

firms having a negative revenue growth rate of -7.4% in year 5. For both years 1 and 2, Type 3

firms have significantly higher revenue growth rates than other NNM firms.

22

To summarize, Type 3 firms continue to perform poorly with respect to other new listings

in the first five years after their initial listings on a variety of different dimensions including

earnings profitability, cash flow profitability, asset growth and revenue growth.

VII. Long-Run Stock Return Performances By Type

We measure the long-run return performances for Type 3 and non-Type 3 firms for three

years following the initial listing date and test if there are marked differences between these two

groups. Our focus is on whether Type 3 listings’ stock market returns differ substantially from

non-type 3 listings’ stock market returns.

Gompers and Lerner (2003), Ritter (1991), Loughran and Ritter (1995), and Ritter and

Welch (2002) present evidence that IPOs underperform in the long run. However, as Ritter and

Welch (2002), demonstrate, long-term abnormal returns vary dramatically over different time

periods. Most germane to this study, they show positive market returns from 1997 and 1998, but

negative long-run returns from 1999 and 2000.

A. First Day Underpricing

We begin by comparing first day underpricing between Type 3 and other listings. We are

able to obtain data for 467 of the 566 Type 3 listings and 211 of the 301 other listings. As Table

X, Panel A shows, the mean day 1 return for Type 3 listings is 70.02% while the mean day 1

return for other listings is 51.00%, significantly different at the 5% level (t-stat 2.51). These

results are not driven by a few outliers, as median returns are 37.50% for Type 3 listings and

19.88% for other listings, significantly different at the 1% level (z-stat 3.70).

We compare these results with Schultz and Zaman (2001), who examine internet IPOs

from 1996 through March 2000. They report a mean underpricing of 80.7% for Internet IPOs,

23

compared to a mean underpricing of other IPOs of 21.6%. Recall that 50.2% of all Internet

listings on the NNM between 1997-Q3 and 2000-Q2 were Type 3 listings, while 37.6% of all

Type 3 listings were Internet companies. (Table IV, Panel B). Thus, our first day return findings

are consistent with Schultz and Zaman (2001).

B. Event-Time Returns

We compute 3-year post-listing abnormal stock returns for Type 3 listings and other

listings using several expected returns methodologies to address the methodological issues

surrounding tests of long-horizon stock performances. Barber and Lyon (1997), Kothari and

Warner (1997) and Lyon, Barber and Tsai (1999) demonstrate how buy-and-hold abnormal

returns (BHARs) are affected by choices of weighting, market indices, and other benchmarks.

Fama (1998) and Mitchell and Stafford (2000) argue that cumulative abnormal returns (CARS)

and calendar-time abnormal returns (CTARs) are superior to BHARs in controlling for cross-

sectional correlations. However, Gompers and Lerner (2003) show that CARs for new listings

are more likely to misrepresent performance than BHARs when returns are highly volatile - a

condition that exists during our time period. Further, Ritter and Welch (2002) and Gompers and

Lerner (2003) argue and show that the long-run performance for IPOs (new listings) is sensitive

to choice of tests and time periods. Because of these papers, we use several methodologies to

examine the three-year long-run performances of type 3 listing and other listings.

Initially, we calculate monthly raw stock returns. This gives an indication of how both

Type 3 and non-Type 3 firms performed over time. Next, we compute monthly abnormal returns

by subtracting from the listing’s return (with dividend yield) three benchmark portfolios: the

CRSP value-weighted index, the return on a size-based portfolio, and the return on a size-based

24

and book-to-market ratio based portfolio. The specifics of the methodologies are presented in

the Appendix.

Table X, Panels B presents raw stock returns by quarter for the three-year period

following the listing date, exclusive of the initial underpricing. In terms of raw returns, Type 3

new listings outperform other new listings during the first three quarters; Type 3 listings rise

20.9% against 4.1% for non-type 3 listings, a difference of 16.8%. We further find that the

relative overperformance peaks at the end of the second quarter – Type 3 firms rise 24.8%

percent higher than other listings. However, by the fourth quarter, the differential in raw returns

drops to only an insignificant 5.6 % (t-stat 0.95). Afterwards, Type 3 firms severely

underperform other new listings. By the end of the third year (12th quarter), Type 3 firms earn a

cumulative -32.3% return, as opposed to the positive 5.8% earned by non-type 3 firms, a

difference significant at the 1% level. Thus, when segregated by type, we find that only the Type

3 new listings experience negative long-run returns.

In Panel C, we present long-run performances relative to benchmark portfolios and find

that the results are consistent with those reported for raw returns. Compared to matched-size

portfolios, Type 3 firms outperform other listings during the first three quarters. The size-

adjusted differential in returns peaks after the second quarter at 21.2%, significant at the 1%

level. However, at the end of three years, Type 3 firms experience a -52.1% BHAR compared to

-12.6% for the other listings, a -39.5% difference that is significant at the 1% level. Size-and-

book-to-market-adjusted returns, as well as market adjusted returns yield similar conclusions.

At this point, we offer three observations. First, Ritter and Welch (2002) report

significantly negative average three-year BHARs for IPOs listing in either 1999 or 2000.16 Since

16 Ritter and Welch (2000) report raw return BHARs of -46.2% and -64.7%, market-adjusted BHARs of -32.9% and -36.4%, and size-and-book-to-market-adjusted BHARs of -74.2% and -42.6%, respectively for 1999 and 2000.

25

many of our sample IPOs occur during these two years, we demonstrate that one main input

driving Ritter and Welch’s (2002) results is the introduction of Type 3 firms into the NNM.

Second, other NNM listings performed much better in the long run. Using raw returns, the

combined 301 Type 1 and Type 2 listings rose 5.8% over three years. In fact, these listings

outperform the market by 4.6% over the same time period (Panel C). Third, while Type 3 firms

show a huge initial run-up in price six months after listing and then a pronounced deterioration

over the next two-and-a-half years, non-type 3 firms show a much steadier performance. Using

raw returns, non-type 3 stocks go up just 7.2% in the first six months and go down just 1.4%

over the next two-and-a-half years. In contrast, Type 3 stocks rise by 31.9% in the first six

months and then drop 64.2% in the following two-and-a-half years.

One implication of the latter finding is that Type 3 stock returns tracked the NASDAQ

Index more closely than other listings’ stock returns from 1997 through 2003, a time period

where the NASDAQ rose and fell precipitously. To confirm this, we compare the mean firm

level correlations in monthly returns between the NASDAQ Stock Index and sample firms for

Type 3 and other listings, using the entire time series of data for a given firm. The mean Pearson

return correlation between the NASDAQ index and the firms is 0.448 for Type 3 firms, and a

significantly lower 0.362 for other listings (t-stat 5.24, difference significant at 1% level).

Similar results are obtained for Spearman rank-order correlations (0.409 for Type 3 and 0.333 for

non-Type 3; t-stat 4.99, difference significant at 1% level). Thus, we conclude that Type 3 firms

more closely tracked the “NASDAQ bubble” than other listings.

VIII. Annualized Stock Return Volatilities for Type 3 and Other New NNM Listings

The low profitability, changes in asset growth rates, high day 1 underpricing, and large

price swings that we document for Type 3 firms suggest they are extremely risky. Pástor and

26

Veronesi (2004) present a valuation model mapping uncertainty about average future

profitability into stock return volatility. Consistent with these assertions, they show a

pronounced upward shift in return volatility for the NASDAQ index from 1998 through 2001

compared to the previous thirty-five years. Our findings, along with Pástor and Veronesi (2004),

suggest that Type 3 firms should exhibit higher return volatility than other NNM new listings

and the NASDAQ index as a whole.

We test for differences in return volatilities between Type 3 firms, other new listings and

the NASDAQ as a whole using two different methodologies. First, we measure firm level return

volatility. We define �Reti as the standard deviation of all available returns for firm i in a given

annual period, annualized by multiplying by 252 . We take the average across the firms in the

portfolio, including all firms with at least 50 valid return observations in the relevant annual

period. This measure is consistent with Campbell et al. (2001), who study firm-specific

volatilities. Second, we measure return volatility at the portfolio level. Specifically, �Port is the

standard deviation of daily value weighted portfolio returns in a given year, annualized by

multiplying by 252 . The portfolio approach is similar to Pástor and Veronesi (2004).

Panels A, B and C of Table XI contain the results averaged across individual firms (�Ret).

In Panel A, we compare all new listings on the NNM with the NASDAQ index on a calendar-

year basis. In Panel B, we compare Type 3 new listings with other new NNM listings by

calendar-time. Panel C compares Type 3 and other NNM new listings by event time.

As Panel A shows, from 1999 through 2003, all new listings on the NNM display higher

return volatilities than the NASDAQ index. Consistent with Pástor and Veronesi (2004), the

NASDAQ index’s volatility rises between 1998 and 2000 and declines thereafter. Similarly, all

new listings on the NNM follow the same trend, with volatility rising till 2000 and falling

27

thereafter. This rise and decline in volatility mirrors the number of new and surviving firms on

the NNM, suggesting that more volatile firms leave the NNM either through delisting or merger.

Panel B shows that Type 3 listings are significantly more volatile than other listings

throughout the 1998 – 2003 period (with the exception of 2002). The differential between Type

3 and other new listings’ mean volatility ranges from 23.0% in 2000 to 32.1% in 1998. As in

Panel A, the peak volatility is in 2000, with a mean firm-level return volatility of 132.9% for

Type 3 firms and 109.8% for other new listings. We also find (non-tabulated) that Type 3 firms

are also more volatile than the NASDAQ for each year between 1999 and 2003, with the

differential ranging from 15.9% in 1999 to 26.6% in 2001. Thus, on a year to year basis, Type 3

listings exhibit significantly greater mean return volatility than other NNM listings and the

NASDAQ as a whole.

We find similar results in event time. As Panel C shows, Type 3 firms have significantly

higher return volatilities than other new listings for the first three years following listing. The

differences are 25.3% for year 1, 26.9% for year 2, and 18.1% for year 3. The differences are

insignificant thereafter, presumably because of survivorship bias, especially in Type 3 firms.

In Panels D and E, we present volatilities using portfolios instead of individual stocks.

The results with portfolios are similar to the firm-level results, except that averaging over

portfolios produces markedly lower volatilities. In Panel D, we compare all new NNM listings to

the NASDAQ index. We find that the return volatilities for all new listings are greater than the

NASDAQ index for 1998 through 2000. Since our methodology is similar to Pástor and

Veronesi (2004), we compare our NASDAQ index volatilities to theirs: Like Pástor and

Veronesi (2004), our NASDAQ index’s volatility increases steadily, from 26.4% in 1998 to

28

48.8% percent in 2000, then declines steadily afterwards. In addition, our NASDAQ index

volatilities are similar to what they report: 48.8% to 47% in 2000 and 34.5% to 34% in 2002.

In Panel E, we compare the volatilities of Type 3 firms with other NNM listings, and with

the NASDAQ index. The portfolio results corroborate the firm level results, as the portfolio of

Type 3 firms exhibits significantly greater stock return volatility than other new NNM listings

and the NASDAQ index in almost every year. Thus, as expected Type 3 stocks display greater

stock return volatilities than other NNM new listings and the NASDAQ index. These findings

are consistent with Type 3 stocks being riskier than other NASDAQ firms.

IX. Summary and Conclusions

We offer a new, empirical explanation for the increase in unprofitable, risky securities

that entered the NNM in the late 1990’s. In August 1997, the NASDAQ changed its initial

listing requirements by introducing a market capitalization standard to the NNM. Unlike

previous listing standards, under which firms had to have minimum net tangible assets and/or

positive income (Type1 and Type 2), the new listing standard allowed firms to enter the NNM if

they had a minimum of $75 million in market capitalization (Type 3).

We examine three aspects of this new listing standard. First, we look at the impact of the

standard on the composition of the NNM. Between August 22nd 1997, the introduction of the

new standard and June 30th 2000, the end of the NASDAQ bubble, 566 firms newly listed as

Type 3 firms, against 301 newly-listed other NNM firms. Type 3 firms accounted for, at their

peak, 10.4% of the number all NNM traded firms (2000-Q3) and 14.2% of total market

capitalization of the NNM (2000-Q1). The new listing standard hence played a significant role

in determining the make-up of the NNM in the late 1990’s-early 2000’s.

29

Second, we examine the validity of the NASDAQ’s justification for the new listing

standard. The NASDAQ argued that many “NNM caliber firms” were unable to list because

accounting regulations limited their tangible assets or reduced their income. Specifically, the

NASDAQ cited the goodwill created when a firm purchases another and depreciation expenses

for telecom firms. To test this, we recast goodwill as a non-depreciable tangible asset and

eliminate depreciation expenses from all Type 3 telecom listings. We find that fewer than 5% of

the 566 Type 3 firms would have met the Type 1 or 2 requirements. This indicates that the

NASDAQ’s rationale was more of a straw man than an actual deterrent to listing.

Finally, we compare Type 3 firms to other NNM listings over our time period in terms of

financial characteristics, long-run firm performance and stock return volatility. In all

dimensions, we find Type 3 firms to be significantly different from other NNM listings. Type 3

firms are extremely unprofitable in terms of income and operating cash flows when they list, and

remain unprofitable over the next five years. In contrast, other NNM listings are profitable when

they list and remain profitable over the next five years. Type 3 firms initially experience higher

asset and revenue growth rates than other new listings; however, one or two years after listing,

the differentials in growth rates either disappear or become more negative for Type 3 firms.

In terms of stock return performance, we find that Type 3 firms significantly outperform

other new listings for the first nine months, but that after two and three years, they significantly

underperform the other new listings. Using raw returns, Type 1 and 2 firms earn, on average,

4.1% after nine months and 5.8% after three years. In contrast, Type 3 firms earn, on average,

20.9% after nine months, but lose 32.3% after three years. These findings are robust to a variety

of return specifications. Finally, we find that for most years between 1998 and 2003, Type 3

firms experience higher stock return volatilities than the NASDAQ index and other new listings.

30

Did the introduction of a purely market capitalization listing standard have an impact on

the NNM? Our answer is a resounding “yes.” The more interesting question, however, is

whether the market capitalization listing standard produced “NNM caliber firms” as the

NASDAQ contended, or whether it allowed a new cadre of inferior firms to enter the NNM. We

find that the market capitalization listing standard significantly lowered the financial threshold of

entering NNM companies and allowed a new cadre of inferior firms to list. As a result, the

NNM saw an influx of highly unprofitable, risky firms that ultimately rose and fell with the

NASDAQ bubble of the late 1990s.

31

Appendix

Methodologies for Computing Event-Time Returns

Returns are obtained from CRSP. Compounding is started from the first available data point on CRSP, excluding the firm’s first day underpricing. Firms are matched to the corresponding portfolio each year for calculating buy and hold returns for the control portfolio. As CRSP calculates its portfolios annually, the composition of the control portfolio for a given firm could change from time to time.

The buy-and-hold abnormal return, compounded monthly, for each firm is computed as:

BHARi,t = ∏∏==

++N

1tBt

N

1tit )R (1 - )R (1 (1)

where: BHARit = Buy and hold abnormal return for firm i over time period t Rit = firm i’s raw return over time period t RBt = return for the benchmark portfolio B over time period t N = # of days The average buy-hold abnormal return for all firms over time period t is computed as:

n

)R (1 - )R (1 BHAR

N

1tBt

N

1tit

t

∏∏�==

++= (2)

where: BHAR t = Average buy-hold abnormal return for all firms over time period t n = # of firms

The t-statistics for the BHAR values are computed as:

tBHAR = n / )(BHAR

BHAR

ti,

ti,

σ (3)

where: )(BHAR ti,σ = Cross-sectional sample standard deviation of abnormal returns for

the sample of n firms. For raw returns, RBt is equal to zero. For size-adjusted returns, the raw return for each

sample firm is adjusted by subtracting the return of a portfolio of stock in the same size-decile (market capitalization) as the sample firm. The matching is done initially for all NYSE-AMEX-NASDAQ firms at the beginning of the listing month. Following Mitchell and Stafford (2000), benchmark portfolios are constructed every year. The third approach adjusts raw returns with a benchmark portfolio based on the listing firm’s size and book-to-market ratio. The entire sample of NASDAQ firms is divided each calendar year into ten size portfolios based on market capitalization. Each decile is then further divided into five quintiles of book-to-market, defined as the book value of equity divided by the market value of equity, both measured initially at the beginning of the listing month. This produces 50

32

benchmark portfolios. Each sample firm is then matched with one of the 50 portfolios formed in month t-1. The benchmark portfolios are newly constructed each year.

If a sample firm does not survive the three-year post-event period, we use the delisting return for the firm in month t and set the return on the firm and the return on the benchmark portfolio equal to zero. If there is no delisting return, we follow Shumway (1997) by setting the delisting return to -55% for NASDAQ firms. All but 39 new lists have a delisting return.

33

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34

Lyon, John D., Brad M. Barber, and Chih-Ling Tsai, 1999, Improved methods of long-run

abnormal stock returns, Journal of Finance, 165-201. Mitchell, Mark L., and Erik Stafford, 2000, Managerial decisions and long-term stock price

performance, Journal of Business 73, 287-329. NASDAQ, 2002, The NASDAQ Stock Market: Historical and Current Listing Standards and

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Working Paper, University of Chicago. Ritter, Jay, 1991, The long-run performance of initial public offerings, Journal of Finance 52,

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the value in Internet stocks, Working Paper, UCLA, University of Chicago, University of California-Berkeley.

35

Table I

NASDAQ National Market (NNM) Alternative Financial Standards for New Listings Before and After August 22nd 1997

This table presents the NASDAQ’s alternative financial listing standards for firms entering the NNM as published by the NASDAQ (2002). Panel A contains the two alternative listing standards in effect between August 30, 1991 and August 21, 1997. Panel B presents the three alternative listing standards in effect between August 22, 1997 and June 28, 2001. Over each time period, a firm could initially list on the NNM if it met one of the stated thresholds. We denote each threshold by type, for example, in Panel A, we denote the two standards as Type 1 and Type 2. In Panel B, we denote the three standards as Type 1, Type 2, and Type 3.

Panel A: Alternative Initial Listing Standards from 8/30/91 Through 8/21/97

Type 1 Type 2 Net Tangible Assets

$4,000,000

$12,000,000

Net Income (in last fiscal year or 2 of last 3 fiscal years)

$400,000

-

Panel B: Alternative Initial Listing Standards from 8/22/97 Through 6/28/01

Type 1 Type 2 Type 3

Net Tangible Assets

$6,000,000

$18,000,000 -

Pretax Income (in last fiscal

year or 2 of last 3 fiscal years)

$1,000,000

-

-

Market Capitalization

Total Assets

Total Revenue

-

-

$75,000,000

or ($75,000,000

and $75,000,000)

36

Table II Sample Selection and Data Availability

This table presents the methods by which we construct our final sample of of 867 new listings on the NASDAQ National Market (NNM) system between Aug 22nd 1997 and June 30th 2000. Panel A presents a summary of how the sample was selected. Panel B links our sample with samples of other recent studies examining new listings.

Panel A: Sample Selection

Criterion Number of firms

1.) Firms that started listing on the NASDAQ between Aug 22, 1997 and June 30, 2000, as identified by CRSP. 1541

MINUS: Firms with SIC Code between 6000 and 6999 (financial firms). (260) 2.) Non-Financial Firms satisfying 1.) 1281

MINUS: Firms that are deleted because their shares were units, the IPO was a reverse LBO, spin-off or not the first IPO. (89)

3.) Firms that are not units, reverse LBOs, spin-offs or non-first IPOs satisfying 2.) 1192 MINUS : Firms with share codes that are not 10 or 11 (ordinary common stock) (168)

4.) Ordinary common stock listings satisfying 3.) 1024 MINUS : Firms that are also listed in other exchanges and tracking stocks (62)

5.) Firms listed solely on the NASDAQ that are not tracking stocks and satisfy 4.) 962 PLUS: Additional IPOs identified in Fama and French (2004) that are not in our sample 158

6.) Augmented Sample satisfying 5.) 1120 MINUS : Firms that do not meet NNM Listing requirements (Types 1,2,3) based on financials* (253)

Final Sample 867

Panel B: Classification of Firms by Data Availability

Category

Number of firms

Proportion

1. Firms Identified as IPO by us (using Thomson SDC Data) as well as by Fama and French (2004)

549 63.3%

2. Firms Identified as IPO by us (using Thomson SDC Data), but not Fama and French (2004)

99 11.4%

3. Firms Identified as IPO by Fama and French (2004), but not by us 102 11.8% 4. Firms not identified as IPO by either of us (non-IPO firms) 117 13.5%

Final Sample

867

100%

Note: * Of the 253 firms that do not meet the NASDAQ listing requirements for either Type 1, 2 or 3 firms, 131 meet the NASDAQ listing requirements for small capitalization stocks.

37

Table III Classification of NNM New Listings by Type Based on Alternative Listing Requirements

This table classifies firms into Type 1, Type 2, or Type 3 based on the three alternative initial NNM financial listing requirements in effect between August 22, 1997 and June 30, 2000. We classify firms sequentially. If, at listing time, a firm has net tangible assets >= $6 million and pretax income >= $1 million, we call it a Type 1 firm. If not, a firm with net tangible assets >= $18 million is classified as a Type 2 firm. If the firm does not satisfy the Type 1 or 2 requirements, but has at least $75 million in total assets and revenues, or a market capitalization of $75 million, we call it a Type 3 firm. Panel A presents the classifications for the full sample of 867 NNM new listings. Panel B breaks down the 566 Type 3 new listings by whether they satisfy one or both of the two alternative initial Type 3 listing requirements. To be listed as a Type 3 firm, the firm must have either (1) a market capitalization of at least $75 million or (2) at least $75 million in total assets and $75 million in total revenues. Figures in brackets are proportions of all Type 3 firms. Panel C presents the classifications by quarter, beginning in the 3rd quarter of 1997 (1997 – Q3) and ending in the 2nd quarter of 2000 (2000 – Q2). Figures in brackets are proportion of all new listings in that quarter.

Panel A: Classification of Firms Based on Alternative NNM Listing Requirements

Type Number of firms Proportion Type 1 182 21.0% Type 2 119 13.7% Type 3 566 65.3% Total 867 100%

Panel B: Numbers of Firms Satisfying Each of the Two Alternative Minimum Requirements for Type 3

Initial Listing

Revenues & Assets >= 75 MM

Revenues or Assets < 75 MM

Market Capitalization >= 75 MM

25 firms (4.4%)

529 firms (93.5%) 554 firms (97.9%)

Market Capitalization < 75 MM

12 firms (2.1%) Must satisfy at least One of the two criteria

12 Firms (2.1%)

37 firms (6.5%) 529 firms (93.5%) 566 firms (100%)

38

Panel C: Number and Proportion of Firms By Type By Quarter

Quarter Type 1 Type 2 Type 3 Total

1997 – Q3 8 2 13 23 (34.8%) (8.7%) (56.5%) (100.0%)

1997 – Q4 37 5 41 83 (44.6%) (6.0%) (49.4%) (100.0%)

1998 – Q1 17 6 25 48 (35.4%) (12.5%) (52.1%) (100.0%)

1998 – Q2 33 6 40 79 (41.8%) (7.6%) (50.6%) (100.0%)

1998 – Q3 8 6 24 38 (21.1%) (15.8%) (63.2%) (100.0%)

1998 – Q4 3 0 16 19 (15.8%) (0.0%) (84.2%) (100.0%)

1999 – Q1 15 10 25 50 (30.0%) (20.0%) (50.0%) (100.0%)

1999 – Q2 16 14 76 106 (15.1%) (13.2%) (71.7%) (100.0%)

1999 – Q3 15 11 77 103 (14.6%) (10.7%) (74.8%) (100.0%)

1999 – Q4 12 4 107 123 (9.8%) (3.3%) (87.0%) (100.0%)

2000 – Q1 9 32 64 105 (8.6%) (30.5%) (61.0%) (100.0%)

2000 – Q2 9 23 58 90 (10.0%)

(25.6%) (64.4%) (100.0%)

39

Table IV Industry Distribution of Type 3 New Listings and Non-type 3 New Listings

This table presents NNM new listings by industry defined by the firm’s primary 3-digit SIC code. Panel A contains the industry distribution for 566 Type 3 new listings and 301 Type 1 & 2 new listings. For Panel B, we identify internet firms from amongst our sample, using Ritter’s internet IPO database. 424 Internet firms went public in the time period analyzed in this paper (between Aug 22nd 1997 and June 30th 2000). We classify these internet firms by listing type. The 156 Ritter internet firms that we classify as other are either small-cap firms or listed on other exchanges.

Panel A: Industry Distribution of New Listings by Listing Type

Type 3 Listings Type 1&2 Listings 3- Digit SIC Description Number Proportion Number Proportion 283 Drugs 26 4.6% 13 4.3% 357 Computer and Office Equipment 20 3.5% 7 2.3% 366 Communications Equipment 17 3.0% 13 4.3% 367 Electronic Components and Accessories 22 3.9% 20 6.6% 382 Measuring and Controlling Devices 10 1.8% 5 1.7% 384 Medical Instruments & Supplies 6 1.1% 3 1.0% 481 Telephone Communication 32 5.7% 15 5.0% 483 Radio and Television Broadcasting 12 2.1% 3 1.0% 484 Cable and Other Pay Television Services 6 1.1% 3 1.0% 489 Communications Services 5 0.9% 5 1.7% 573 Radio, Television, & Computer Stores 7 1.2% 3 1.0% 581 Eating and Drinking Places 4 0.7% 5 1.7% 594 Misc. Shopping Goods Stores 4 0.7% 4 1.3% 596 Non-store Retailers 8 1.4% 4 1.3% 731 Advertising 11 1.9% 2 0.7% 737 Computer and Data Processing Services 211 37.3% 59 19.6% 738 Misc. Business Services 33 5.8% 8 2.7% 809 Misc. Health and Allied Services 2 0.4% 4 1.3% 873 Research and Testing Services 18 3.2% 2 0.7% 874 Management & Public Relations 7 1.2% 6 2.0% Rest 105 18.6% 117 38.9% Total 566 301

Panel B: Internet New Listings According to Listing Type

Listing Type Number % of All Internet New Listings % of Type that are Internet Firms Type 1 or 2 55 13.0% 18.3% (of 301) Type 3 213 50.2% 37.6% (of 566) Other 156 36.8% Total 424 100%

40

Table V Type 3 Listings as a Proportion of NNM over Time

This table presents both the number of Type 3 listings and the percentage of the total NNM that Type 3 listings are between the fourth quarter of 1997 (1997 – Q4) and the fourth quarter of 2003 (2003 – Q4). The left-side of the table presents the number of Type 3 firms traded at the end of the quarter and its proportion (% Type 3) of total NNM firms at the end of the quarter. The right-side of the table presents the total market capitalization of Type 3 firms in billions of dollars at the end of the quarter and its proportion (% Type 3) of the total capitalization of the NNM at the end of the quarter. Time Period

Number of Firms on

NNM

Number of Type 3 Firms

% Type 3 Total Market Capitalization of

NNM ($ Billion)

Total Market Capitalization of

Type 3 Firms ($ Billion)

% Type 3

1997 – Q4 5484 43 0.8% 1832.4 10.4 0.6% 1998 – Q1 5405 72 1.3% 2180.6 18.7 0.9% 1998 – Q2 5370 101 1.9% 2273.5 29.8 1.3% 1998 – Q3 5245 138 2.6% 2028.9 26.6 1.3% 1998 – Q4 5068 145 2.9% 2606.7 47.7 1.8% 1999 – Q1 4928 168 3.4% 2871.0 72.0 2.5% 1999 – Q2 4877 219 4.5% 3165.5 129.9 4.1% 1999 – Q3 4829 303 6.3% 3320.2 207.9 6.3% 1999 – Q4 4808 389 8.1% 5218.2 485.5 9.3% 2000 – Q1 4811 437 9.1% 6237.1 883.3 14.2% 2000 – Q2 4846 497 10.3% 5620.0 450.1 8.0% 2000 – Q3 4862 505 10.4% 5359.6 670.0 12.5% 2000 – Q4 4699 481 10.2% 3611.4 309.7 8.6% 2001 – Q1 4557 457 10.0% 2698.5 219.4 8.1% 2001 – Q2 4356 427 9.8% 3159.1 202.9 6.4% 2001 – Q3 4191 393 9.4% 2177.2 147.3 6.8% 2001 – Q4 4084 374 9.2% 2855.8 156.5 5.5% 2002 – Q1 3979 360 9.0% 2710.9 127.2 4.7% 2002 – Q2 3865 347 9.0% 2139.5 114.0 5.3% 2002 – Q3 3753 332 8.8% 1702.5 85.7 5.0% 2002 – Q4 3655 322 8.8% 1953.1 99.9 5.1% 2003 – Q1 3525 301 8.5% 1951.6 86.5 4.4% 2003 – Q2 3432 284 8.3% 2366.1 116.5 4.9% 2003 – Q3 3359 274 8.2% 2628.3 133.3 5.1% 2003 – Q4 3323 259 7.8% 2947.0 146.4 5.0%

41

Table VI The Effects that Goodwill Accounting Had on Firms Entering the NNM

This table analyzes the effects that goodwill accounting had on firms entering the NNM. Panel A presents the mean values for assets, liabilities, total goodwill, the total amortization of the goodwill, net assets and net tangible assets from the firms’ balance sheets by type. Net Assets are defined as total assets minus total liabilities. Net Tangible Assets is defined as net assets minus goodwill. All items, except proportions, are in million of dollars. The t-statistics (t-stat) are for differences of means tests, using pooled estimates of standard error. The level of significance is indicated by *** (1%), ** (5%), * (10%) using a two tailed test. In Panel B, we recast the firms’ financial numbers by treating goodwill as if it were a non-depreciable tangible asset. Using these recast numbers, we present the number of Type 3 firms that would have entered the NNM as Type 1, Type 2, or Type 3 firms.

Panel A: Comparisons Between Type 3 and Other (Type 1 or 2) New Listings

Characteristic Type 3 (566 firms)

Type 1 or 2 (301 firms)

Difference t-stat

Total Assets 76.6 289.9 -213.3 -3.16***

Liabilities 69.8 169.9 -100.1 -2.35**

Goodwill 4.9 8.2 -3.4 -0.86 Total Amortizations 0.3 0.7 -0.4 -1.67*

Net Assets 6.6 119.9 -113.3 -3.93***

Net Tangible Assets 1.7 111.7 -110.0 -3.88***

Goodwill/ Assets 3.3% 1.5% 1.8% 3.23***

Goodwill/Net Assets 9.3% 3.9% 5.5% 2.16**

Panel B: Listing Effects of Excluding Goodwill from Tangible Assets

from Type 3 New Listings

Classification under Modified Accounting

Goodwill Added to Tangible Assets

Amortizations Added to Pretax Income

Both

Type 1 15 3 16 Type 2 8 0 7 Type 3 543 563 543

42

Table VII The Effects of Depreciation on Telecommunication Firms Entering the NNM

This table presents the effects of depreciation on telecommunication firms (Telecom) entering the NNM. Of the 867 new listings, 87 are telecommunications. Of the 87 telecommunication firms, 60 entered the NNM as Type 3 firms and 27 entered the NNM as Type 1 or Type 2 firms. Panel A presents the depreciation expense, accumulated depreciation, revenues, assets, tangible assets, and pre-tax income for the Telecom and non-Telecom new listings. All items, except proportions, are in million of dollars. Panel B compares the same balance sheet and income statement items for the 60 Type 3 and 27 Type 1 or Type 2 Telecoms. T-statistics (t-stat) are for differences of means tests, using pooled estimates of standard error. The level of significance is indicated by *** (1%), ** (5%), * (10%) using a two tailed test. In Panel C, we recast the 60 Type 3 Telecoms’ financial numbers by treating PP&E as if it were a non-depreciable tangible asset. Using these recast numbers, we present the number of Type 3 Telecoms that would have entered the NNM as Type 1, Type 2, or Type 3 firms.

Panel A: Comparison of Telecom and Non-Telecom New Listings (All Listing Types) Characteristic Telecom

(87 firms) Non-Telecom

(780 firms) Difference t-stat

Depreciation Expense 8.4 9.4 -1.0 -0.33 Accumulated Depreciation 13.3 31.6 -18.3 -1.50 Revenues 42.7 137.6 -94.9 -2.69***

Total Assets 281.2 136.9 144.3 2.07**

Tangible Assets 82.5 35.8 46.7 1.21 Pre-tax Income -25.4 -3.3 -22.2 -3.31***

Depreciation Expense/Revenues 23.2% 9.9% 13.3% 4.81***

Depreciation Expense/Assets 5.0% 5.4% -0.5% -0.73 Accumulated Depreciation/Assets 6.8% 11.9% -5.1% -3.90***

Panel B: Comparison of Telecom New Listings: Type 3 vs. Type 1 or 2

Characteristic Type 3 Telecom (60 firms)

Type1 or 2 Telecom (27 firms)

Difference t-stat

Depreciation Expense 5.0 15.7 -10.8 -2.16**

Accumulated Depreciation 5.3 30.6 -25.3 -2.38**

Revenues 28.5 73.1 -44.6 -2.77***

Total Assets 193.2 470.3 -277.1 -2.04**

Tangible Assets 41.5 169.2 -127.7 -1.43 Pre-tax Income -24.0 -28.5 4.5 0.33 Depreciation Expense/Revenues 21.6% 25.8% -4.2% -0.69 Depreciation Expense/Assets 5.6% 3.6% 2.0% 2.01**

Accumulated Depreciation/Assets 6.4% 7.5% -1.1% -0.42

Panel C: Listing Effects of Adjusting for Depreciation and Accumulated Depreciation on 60 Type 3 Telecom New Listings

Accounting Adjustment Type 1 Type 2 Type 3 Depreciation added back to Pre-tax Income

1 0 59

Accumulated Depreciation added back to Tangible Assets

1 1 58

Both 4 0 56

43

Table VIII Comparison of Financial Characteristics of Firms by Type at the Time of Listing

This table compares financial characteristics between Type 3 and Type 1 or 2 firms at the time of listing. The financial characteristics are assets, revenues, operating income, net income, cash flows from operations, asset growth, revenue growth, market value of equity and book value of equity. The proportion negative net income is the percentage of all firm-types that report negative net income. The proportion negative cash flow is the percentage of all firm-types that report negative cash flow. Panel A presents mean financial characteristics. T-statistics (t-stat) are for differences of means tests, using pooled estimates of standard error. Panel B presents median financial characteristics. Z-statistics (z-stat) are for differences of medians tests. The level of significance is indicated by ***

(1%), ** (5%), * (10%), using a two-tailed test.

Panel A: Mean Financial Characteristics

Financial Characteristic Type 3 (566 firms)

Type 1 or 2 (301 firms)

Difference t-stat

N Mean N Mean Assets ($ million) 549 78.5 301 285.4 -206.9 -3.12*** Revenues ($ million) 537 56.8 299 265.5 -208.7 -2.43** Operating Income ($ million) 532 -0.3 298 29.6 -30.0 -1.98** Net Income ($ million) 536 -10.7 299 -4.2 -6.5 -0.89 Operating Income/Assets 532 -50.0% 298 2.2% -52.1% -14.10*** Net Income/ Assets 536 -64.5% 299 -6.4% -58.1% -14.26*** Proportion Negative Net Income 549 81.1% 301 39.9% 41.2% 12.54*** Proportion Negative Cash Flow 549 76.5% 301 40.9% 35.6% 10.59*** Cash from Operations ($ million) 537 -1.3 298 17.8 -19.1 -1.87* Cash From Operations/Assets 537 -37.9% 298 -0.5% -37.4% -13.61*** Asset Growth 295 218.3% 235 237.5% -19.2% -0.68 Revenues Growth 264 231.1% 212 178.2% 53.0% 1.88* Market Value of Equity ($ million) 538 451.7 266 598.0 -146.3 -1.62 Book Value of Equity ($ million) 549 -8.7 299 101.6 -110.3 -3.83***

Panel B: Median Financial Characteristics

Financial Characteristic Type 3 (566 firms)

Type 1 or 2 (301 firms)

Difference z-stat

N Median N Median Assets ($ million) 549 14.5 301 62.7 -48.2 -15.86*** Revenues ($ million) 537 9.9 299 53.2 -43.3 -12.92*** Operating Income ($ million) 532 -4.1 298 6.6 -10.7 -8.90*** Net Income ($ million) 536 -6.2 299 1.7 -8.0 -7.76*** Operating Income/Assets 532 -34.7% 298 11.5% -46.1% -12.76*** Net Income/ Assets 536 -45.8% 299 3.0% -48.8% -13.73*** Cash from Operations ($ million) 537 -3.1 298 2.7 -5.7 -7.56*** Cash From Operations/Assets 537 -25.7% 298 4.1% -29.8% -11.83*** Asset Growth 295 105.4% 235 67.1% 38.2% 0.18 Revenues Growth 264 96.4% 212 50.8% 45.6% 3.08*** Market Value of Equity ($ million) 538 244.3 266 210.8 33.5 1.84* Book Value of Equity ($ million) 549 -2.0 299 20.1 -22.0 -14.70***

44

Table IX Financial Characteristics Across Event Time

This table presents financial characteristics of all trading securities by type over time. NI/Assets is net income before extraordinary items divided by total assets. OI/Assets is operating income divided by total assets. CFO/Assets is cash flows from operations divided by total assets. AGR is the change in assets divided by last year’s assets. RGR is the change in revenues divided by last year’s revenues. The table presents the median performance in event time, where year 1 is one year after the listing date and years 2 through 5 are subsequent years. Z-statistics are for differences of medians tests. The level of significance is indicated by *** (1%), ** (5%), * (10%) using a two tailed test.

Metric TYPE Year 1 Year 2 Year 3 Year 4 Year 5 NI/Assets All New Listings -8.9% -11.6% -16.2% -11.2% -4.7% Type 3 -14.3% -21.8% -30.0% -21.8% -10.9% Type 1 or 2 1.7% 0.3% -3.0% -1.1% 0.3% Difference -16.0% -22.1% -27.0% -20.7% -11.2% z-statistic -9.86*** -8.00*** -8.02*** -6.44*** -3.16*** OI/Assets All New Listings -4.8% -3.7% -4.5% 1.0% 6.0% Type 3 -11.3% -12.8% -13.4% -5.5% -0.8% Type 1 or 2 9.7% 7.9% 4.9% 9.0% 8.4% Difference -21.0% -20.7% -18.3% -14.5% -9.2% z-statistic -10.41*** -8.98*** -8.49*** -6.73*** -3.52*** CFO/Assets All New Listings -3.9% -4.1% -3.0% 0.8% 5.2% Type 3 -7.9% -8.7% -9.5% -4.7% 2.8% Type 1 or 2 3.0% 3.2% 4.2% 6.1% 6.6% Difference -10.9% -11.8% -13.7% -10.8% -3.9% z-statistic -9.23*** -8.20*** -7.78*** -6.53*** -2.91*** AGR All New Listings 251.7% 11.9% -5.7% -7.2% -7.6% Type 3 433.8% 11.4% -13.2% -13.9% -11.5% Type 1 or 2 103.1% 12.3% 4.1% -2.1% -4.1% Difference 330.7% -0.9% -17.3% -11.9% -7.4% z-statistic 12.43*** 0.31 -4.86*** -3.52*** -2.22*** RGR All New Listings 97.2% 52.4% 8.7% 2.0% -3.0% Type 3 124.2% 78.1% 7.8% 1.2% -7.4% Type 1 or 2 55.3% 26.8% 9.0% 2.6% 0.8% Difference 68.8% 51.3% -1.2% -1.4% -8.1% z-statistic 7.40*** 7.59*** -0.31 -0.24 -1.20 Number of All New Listings 839 753 645 436 183 Observations Type 3 543 485 404 275 97 Type 1 or 2 296 268 241 161 86

45

Table X Cumulative Buy and Hold Return (BHARs) Performances by Event Time

This table presents stock returns for firms by type. Returns are from CRSP. Panel A presents the IPO underpricing premium on day 1 for Type 3 and Type 1 or 2 firms. IPO Day 1 Returns are available for 467 of 566 Type 3 new listings and 211 of 301 Type 1 or 2 new listings. Panel B has cumulative buy and hold raw returns by quarter for three years following the new listing. Compounding starts from the first available data point on CRSP (excluding day 1 underpricing). All returns are buy and hold. When a firm delists, its delisting return is used. Panel C has cumulative buy and hold abnormal returns (BHARs). Size-adjusted returns are calculated by subtracting the buy and hold returns for the portfolio of firms in the same CRSP capitalization decile as the firm from the firm’s buy and hold raw returns. As CRSP calculates its portfolios annually, the composition of the control portfolio for a given firm could change from time to time. For the size and B/M adjusted returns, the entire sample of NASDAQ firms is divided each calendar year into ten deciles based on market capitalization, and each decile is then further divided into five quintiles of book-to-market. Firms are matched to the corresponding portfolio each year for the calculation of the buy and hold returns for the control portfolio. Market-adjusted returns are the raw return minus the CRSP value-weighted index. T-statistics (tstat) are for differences of means tests, using pooled estimates of standard error. The level of significance is indicated by *** (1%), ** (5%), * (10%) using a two tailed test.

Panel A: IPO Underpricing (Day 1 Return)

Panel B: Mean Raw Cumulative Buy and Hold Returns

Raw Returns Qtr After Listing Type 3 (N=566) Type 1 or 2 (N=301) Difference t-stat 1 15.0% 2.1% 12.9% 4.03***

2 31.9% 7.2% 24.8% 4.41***

3 20.9% 4.1% 16.8% 2.85***

4 5.7% 0.1% 5.6% 0.95 5 7.3% 4.3% 3.0% 0.35 6 -7.1% -0.9% -6.2% -0.81 7 -9.0% 4.1% -13.1% -1.64*

8 -13.3% 10.8% -24.2% -2.32**

9 -21.6% 7.5% -29.1% -2.78***

10 -21.1% 10.6% -31.7% -2.23**

11 -28.3% 6.8% -35.2% -2.51***

12 -32.3% 5.8% -38.1% -2.71***

Type 3 (N=467)

Type 1 or 2 (N=211)

Difference t-stat

Mean Return 70.02% 51.00% 19.02% 2.51**

Median Return 37.50% 19.88% 17.62% 3.70***

46

Panel C: Mean Cumulative Buy and Hold Abnormal Returns (BHARs)

Size-Adjusted Returns Size and B/M-Adjusted Returns Market-Adjusted Returns Qtr after Listing

Type 3 (N=566)

Type 1 or 2 (N=301)

difference t-stat Type 3 (N=566)

Type 1 or 2 (N=301)

difference t-stat Type 3 (N=566)

Type 1 or 2 (N=301)

difference t-stat

1 12.2% 2.6% 9.6% 3.15*** 10.2% 2.4% 7.8% 2.55*** 12.9% 1.0% 12.0% 3.83***

2 25.6% 4.4% 21.2% 3.90*** 23.5% 3.7% 19.8% 3.66*** 25.8% 2.0% 23.8% 4.31***

3 12.0% 0.7% 11.4% 1.99** 10.4% -0.4% 10.8% 1.92* 13.4% -2.7% 16.1% 2.78***

4 -3.5% -5.0% 1.5% 0.26 -0.1% -5.1% 4.9% 0.86 -1.2% -6.8% 5.6% 0.97 5 -4.4% -2.9% -1.4% -0.16 3.8% -2.1% 5.9% 0.70 0.5% -5.3% 5.8% 0.68 6 -18.5% -9.3% -9.2% -1.21 -5.5% -6.1% 0.6% 0.08 -11.2% -10.0% -1.2% -0.16 7 -25.4% -9.2% -16.2% -2.04** -11.5% -5.4% -6.1% -0.77 -12.4% -5.6% -6.8% -0.88 8 -30.9% -5.2% -25.7% -2.48** -15.3% -1.6% -13.7% -1.34 -14.8% 1.6% -16.5% -1.62*

9 -42.1% -12.4% -29.8% -2.84*** -26.0% -7.3% -18.7% -1.81* -22.4% -2.0% -20.4% -2.00**

10 -41.2% -8.5% -32.7% -2.30** -23.2% -2.3% -20.9% -1.49 -20.0% 3.7% -23.7% -1.71*

11 -48.0% -10.1% -37.9% -2.69*** -28.0% -3.6% -24.3% -1.72* -24.4% 3.5% -27.9% -2.02**

12 -52.1% -12.6% -39.5% -2.81*** -31.3% -5.6% -25.7% -1.81* -26.0% 4.6% -30.6% -2.22**

47

Table XI Stock Return Volatilities for Type 3 and Type 1 or 2 New Listings

This table presents stock return volatilities for all NNM new listings, Type 3 new listings, Type 1 or 2 new listings, and for the NASDAQ index. Panel A compares firm level volatility for all new NNM listings with the NASDAQ index from 1998 through 2003. Panel B compares firm level volatility for Type 3 new listings with Type 1 or 2 new listings from 1998 through 2003. Panel C compares firm level volatility for type 3 new listings with Type 1 or 2 new listings in event time. Firm level volatility, �Reti is the standard deviation of all available returns for a given firm i in a given annual period. A firm needs to have at least 50 valid return observations for volatility to be computed. �Ret is the mean firm level volatility across all firms. Panel D compares portfolio level return volatility for all new NNM listings with the NASDAQ index for 1998 through 2003. Panel E compares portfolio level return volatility for Type 3 new listings with Type 1 or 2 new listings and with the NASDAQ index for 1998 through 2003. Portfolio level volatility, �Port is the standard deviation of daily value weighted portfolio returns in a given year.

Volatilities are annualized by multiplying by 252 . Level of significance is denoted by *** (1 %), ** (5%), * (10%), using a two-tailed difference of means test using pooled standard errors. ____________________________________________________________________________________________________________________________________________________________

Panel A: Comparisons of Mean Firm Level Return Volatilities of All New NNM Listings with NASDAQ Index

Year New NNM Listings NASDAQ difference t-stat N σRet N σRet

1998 265 94.7% 5674 97.5% -2.8% -0.44 1999 558 102.2% 5479 97.4% 4.8% 2.28** 2000 786 124.9% 5283 107.1% 17.8% 10.74*** 2001 701 121.7% 4751 104.2% 17.6% 7.36*** 2002 557 109.2% 4151 88.1% 21.1% 4.90*** 2003 472 77.6% 3764 69.1% 8.5% 3.46***

Panel B: Calendar Time Comparisons of Mean Firm Level Return Volatilities by Listing Type

Year Type 3 Type 1 or 2 difference t-stat N σRet N σRet

1998 140 109.8% 125 77.7% 32.1% 2.73*** 1999 354 112.3% 204 84.8% 27.5% 8.27*** 2000 515 132.9% 271 109.8% 23.0% 7.40*** 2001 449 130.8% 252 105.6% 25.2% 6.05*** 2002 346 108.7% 211 109.8% -1.1% -0.11 2003 290 84.5% 182 66.5% 18.0% 4.11***

Panel C: Event Time Comparisons of Mean Firm Level Return Volatilities by Listing Type Year After IPO Type 3 Type 1 or 2 difference t-stat

N σRet N σRet 1 551 120.8% 287 95.6% 25.3% 7.31*** 2 517 129.5% 278 102.6% 26.9% 6.46*** 3 429 118.2% 244 100.2% 18.1% 4.16*** 4 345 103.3% 215 99.4% 3.9% 0.48 5 216 81.3% 147 79.0% 2.4% 0.30

48

Panel D: Comparisons of Portfolio Level Return Volatilities of All New NNM Listings with NASDAQ Index

Year New NNM Listings NASDAQ difference t-stat N σPort N σPort

1998 265 31.1% 5674 26.4% 4.6% 1.74* 1999 558 39.0% 5479 27.3% 11.8% 5.26*** 2000 786 62.9% 5283 48.8% 14.1% 3.13*** 2001 701 48.1% 4751 43.6% 4.6% 1.04 2002 557 31.6% 4151 34.5% -2.8% -1.40 2003 472 21.1% 3764 22.3% -1.1% -0.55

Panel E: Calendar Time Comparisons of Portfolio Level Return Volatilities by Listing Type Year Type 3 Type 1 or 2 difference t-stat (Type 3 – NASDAQ) t-stat

N σPort N σPort 1998 140 36.9% 125 30.1% 6.8% 1.97** 10.4% 2.94** 1999 354 47.1% 204 35.0% 12.0% 3.58*** 19.8% 5.85** 2000 515 71.2% 271 54.6% 16.5% 3.06*** 22.4% 4.08** 2001 449 58.2% 252 40.3% 17.9% 3.49*** 14.6% 2.81** 2002 346 37.5% 211 28.4% 9.1% 4.25*** 3.0% 1.33 2003 290 24.5% 182 20.9% 3.6% 2.22** 2.2% 1.69*