Venture capital investments by IPO underwriters: Certification, alignment of interest, or moral hazard?*

Xi Li School of Business

University of Miami Coral Gables, FL 33146 Phone: 305-284-6891

Fax: 305-284-4800 x.li@miami.edu

and

Ronald W. Masulis

Owen Graduate School of Management Vanderbilt University Nashville, TN 37203 Phone: 615-322-3687

Fax: 615-343-7177 ronald.masulis@owen.vanderbilt.edu

Current Version: December 29, 2004

*We would like to thank Shane Corwin, Douglas Cumming, Mara Faccio, Laura Fields, Gordon Hanka, Robert Hansen, Yael Hochberg, Jay Ritter, and participants at the 2003 Western Finance Association Annual Meetings, the 2004 Financial Management Association Annual Meetings, and workshops at the New York Federal Reserve Bank, Notre Dame University, Tulane University, Vanderbilt Law School, the University of New Orleans, and the University of Southern California for helpful comments. We also want to thank Alexander Ljungqvist for supplying us with information on SDC New Issues file errors; Sunil Wahal for data on venture capitalist ranking, and the Financial Markets Research Center for financial support. The second author visited the University of New South Wales Banking School while this study was being completed.

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Venture capital investments by IPO underwriters: Certification, alignment of interest, or moral hazard?

Abstract

We study IPO pricing when underwriters are venture capital investors in issuers and test three hypotheses

concerning the effects of underwriter share ownership on the IPO underwriting and pricing processes.

We find that venture investments by underwriters significantly reduce IPO underpricing; and the result is

stronger for lead underwriters. This evidence is consistent with both underwriter certification and

improved underwriter alignment of interests with issuers. The fall in underpricing is substantially greater

when there is greater uncertainty about IPO valuation, which further supports the underwriter certification

effect. Controlling for endogeneity effects does not change our conclusions. Finally, lead underwriter

venture investment in IPO issuers also reduces underwriter gross spreads. Overall, the evidence is

consistent with an underwriter certification effect and to a lesser degree an underwriter-issuer alignment

of interest effect and inconsistent with an IPO conflict of interest effect.

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1. Introduction

Since the early 1990s, many investment banks and large commercial banks have offered venture

capital (VC) services. At the same time, many commercial banks began competing with investment

banks to underwrite equity offerings.1 By integrating venture capital and underwriting services under one

roof, a financial institution obtains potentially valuable issuer-specific information and forges a financial

link with the issuing firm with its equity investment. These two effects can have important impacts on the

initial public offering (IPO) process, such as increasing a financial institution’s incentives to underwrite

an IPO. However, combining financial services under one roof can lead to serious conflicts of interest as

well. This is highlighted by the legal problems that have beset financial institutions that offer both

investment banking and security analysis services to the same client firms. 2 3 This also raises serious

policy issues concerning whether financial institutions should be allowed to offer a broad array financial

services and, if so, under what forms of regulatory constraints. In this study, we examine whether

allowing financial institutions to offer both underwriting services and venture capital to the same firms

has tangible effects on the U.S. IPO offering process and whether the observed effects are detrimental or

beneficial to security issuers or investors.

When financial institutions make venture investments in privately held firms, they generally

receive access to proprietary firm information through board representation or observation rights and

direct access to management. When these institutions later underwrite these firms’ IPOs, these institutions

face altered risks and incentives as they negotiate IPO prices and fees. Such venture investments can

worsen underwriter conflicts of interest with IPO investors, while lessening their conflicts of interest with

issuers. On the other hand, better access to issuer information can result in more thorough due diligence

investigations and greater underwriter credibility in IPO pricing. Depending on underwriting market

competition, syndicate position, issuer investment size, and the cost and credibility of the due diligence

1 The Federal Reserve began allowing limited equity underwriting by commercial banks in the early 1990s through Section 20 subsidiaries. The Gramm-Leach-Bliley Financial Modernization Act of 1999 ended the prohibition on commercial bank underwriting of corporate securities. Chaplinsky and Erwin (2001) provide further details on commercial bank underwriting. 2 For evidence on these issues, see studies by Lin and McNichols (1998) and Michaely and Womack (1999). 3 Accounting firms that offer auditing and consulting services to the same clients create a similar conflict of interest.

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investigation, we obtain very different predictions about underwriter shareholding effects on the IPO

process. This leads to several testable hypotheses concerning the impact of venture investment on IPO

prices, underwriting fees, and long-run performance.

First, underwriters with superior access to issuer information can credibly validate issuer financial

health, thereby increasing investor demand and supporting higher security offer prices [Puri (1999)],

which we term the certification hypothesis. These underwriters could also afford to offer lower

underwriting fees due to their comparative advantage in issuer information production. Second, equity

investments in issuers improve the alignment of underwriter and issuer interests, and thus cause

underwriters to set relatively higher IPO offer prices. We term this process the issuer alignment

hypothesis. Third, pre-existing investments in issuers can create a moral hazard problem between

underwriters and outside investors. By underwriting an IPO, an issuer’s financial condition is

strengthened, and thus the likelihood that the underwriter will sustain a loss on its prior investment in the

issuer is reduced. We term this moral hazard problem, the investor conflict of interest hypothesis. It is

important to recognize that none of these hypotheses are necessarily mutually exclusive in their

predictions.

Our three hypotheses yield distinctly different predictions about how underwriter shareholdings

manifest themselves in the IPO pricing and underwriting processes. Several forms of evidence are

investigated to assess whether and how underwriter shareholdings affect these processes. We first

examine the relation between IPO underpricing and underwriter ownership, where the latter is measured

by percentage shareholdings. We then distinguish between the roles of syndicate members by introducing

indicator variables for lead and nonlead underwriters, since lead underwriters are likely to have greater

influence in setting IPO offer prices. We also distinguish between relatively high and low asymmetric

information IPOs. Finally, we adjust for potential selection bias caused by underwriters’ venture

investment criteria.

Second, we examine the relation between underwriter shareholdings and revisions in IPO offer

prices from the filing ranges’ high-low midpoints. The filing price range is a mechanical function of its

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midpoint and reflects the underwriter's initial due diligence investigation. IPO price revisions capture the

added information produced by underwriters’ continued due diligence investigations and book building

activities4, and are one measure of the accuracy of an underwriter’s initial valuation of the IPO and the

quality of its issuer information. We again distinguish between relatively high and low asymmetric

information IPOs.

Third, we investigate the relation between underwriter shareholdings and underwriting fees, as

well as its three components, which may or may not be set competitively. The key question here is

whether underwriters tend to treat IPO issuers more or less favorably when they are shareholders. While

a large majority of gross spreads are set at 7%, there is noticeable variability in gross spreads for issues

that are relatively larger or smaller than the typical IPO offer size. The marginal effects of a change in

underwriter ownership are likely to be manifested in these offer size ranges. We explore whether

underwriter shareholdings have a larger effect on spreads in relatively high and low asymmetric

information IPOs.

Finally, we examine the relation between underwriter shareholdings and IPO long-run

performance over the following three and five years, measured by exchange delistings that are not

acquisition related and year-end market-to-book value ratios. Delisting frequencies offer a means to

assess whether underwriters’ prior private equity relationships with issuers alter underwriters’ origination

standards and assessments of issuer prospects and risks. The market-to-book ratio is often used as a

proxy for Tobin’s Q, which in turn is used to measure firm financial performance and growth

opportunities. To preview our conclusions, we find evidence consistent with both the certification

hypothesis and the issuer alignment of interest hypothesis, but little evidence in support of the investor

conflict of interest hypothesis.

Following the Introduction, Section 2 develops our hypotheses and reviews the prior research on

IPO underpricing and underwriting fees. In Section 3 data sources and descriptive statistics are discussed.

Section 4 and 5 explore the relation between prior equity investments by underwriters and both IPO

4 See Correlli and Goldreich (2002) for an extensive discussion of bookbuilding.

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underpricing and price revisions from the filing range midpoints. Sections 6 and 7 investigate the relation

between underwriter equity investments and both gross spreads and long-run performance measures. The

conclusions are summarized in the last section.

2. Hypotheses and Related Literature

We evaluate the predictions of our three competing hypotheses for IPO underpricing, (absolute)

price revisions, gross spread, and both stock delisting frequencies and market-to-book ratios in three and

five years following the IPOs. IPO underpricing is measured by the percentage change from offer price to

the first-day closing price, and offer price revision is measured by the offer price minus the filing price

range midpoint scaled by the same midpoint in percentage. Underwriter compensation is measured by

gross spread, defined as total underwriting fees as a percentage of IPO gross proceeds. Delisting of IPO

stocks from all major U.S. exchanges (NYSE, Amex, and Nasdaq) due to financial distress is one measure

of long-run performance that avoids the controversies surrounding appropriate risk benchmarks. The

market-to-book ratio is equal to a firm’s book value of debt plus market value of stock divided by its book

value of assets at the prior year-end.

Several theories of IPO valuation under asymmetric information focus on adverse selection,

underwriter certification, and moral hazard problems, and have implications for the IPO pricing and

underwriting processes. Some theories assume underwriters set market clearing prices and rational IPO

investors demand offer price discounts to compensate them for expected adverse selection effects.5 Given

that the banks with share ownership can cheaply acquire proprietary firm-specific information from their

venture capital relationships, they can lower their information production costs relative to competing

banks and credibly validate issuer financial health, thereby lowering IPO price discounts [Puri (1999)].

Equity investment in issuers also places underwriter capital at risk. This type of investment can send a

credible signal to the market, given both the typical six-month lockup period on venture capital and

5 Adverse selection can be caused by (1) issuers timing offers to avoid periods during which their stock is underpriced (Myers and Majluf (1984)), (2) informed traders competing for underpriced issues (Rock (1986), Beatty and Ritter (1986)), and (3) underwriter allocation of hot issues (Benveniste and Spindt (1989) and Sherman and Titman (2002)).

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underwriter shareholdings, and potential bankruptcy costs.6 Thus, an equity investment enhances an

underwriter’s ability to credibly certify issue quality.7 We term this positive relation between underwriter

ownership and issue quality the certification hypothesis.

Underwriter investments in potential IPO issuers can create a moral hazard problem between

underwriters and outside investors, which can alter underwriter behavior by weakening underwriting

standards. For example, Puri (1999) argues that banks that own securities in financially weak firms have

greater incentives to underwrite high risk issues of these same firms so as to strengthen these issuers’

financial conditions and thereby decrease the likelihood of bank losses on their security investments.

Thus, the investor conflict of interest hypothesis predicts that underwriters have greater incentives to

accept assignments from weak IPO issuers if underwriters are private equity investors, and moreover, that

this incentive is increasing in the underwriter’s fractional ownership.

Several theories presume that underwriters operate in an oligopolistic market in which they have

some power to set IPO offer prices, and several empirical studies report evidence consistent with

underwriter market power.8 Baron and Holmstrom (1980), Baron (1982), and Biais, Bossaerts, and

Rochet (2002) argue that underwriters have information advantages over issuers in setting IPO prices, and

by allocating underpriced IPOs to favored customers, can benefit financially at the expense of issuers. In

addition, Hughes and Thakor (1992) posit that underwriters intentionally underprice IPOs to minimize

their litigation risk from IPO investors who might question the care and accuracy of their due diligence

investigation.

Ljungqvist and Wilhelm (2003), on the other hand, argue that underwriters’ prior equity

investments in issuers can better align the interests of underwriters with issuers, though they do not find a

significant effect on the IPO pricing process. This alignment of interest hypothesis assumes that

underwriters’ equity investments in issuers can cause them to act more as issuer shareholders than

transaction-fee focused underwriters. This effect should cause observed IPO pricing and underwriter fee

6 Field and Hanka (2001) provide a detailed discussion of lock-up provisions and their empirical patterns. 7 An early version of this hypothesis is tested by Booth and Smith (1986), who find empirical support for it.

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decisions to be more favorable for issuers. It is important to recognize that while these three hypotheses

are competing, they are not mutually exclusive in their predictions.

We begin our analysis by examining the IPO underpricing predictions of the three hypotheses.

The certification hypothesis predicts increased investor demand when underwriters have superior access

to issuer information due to their private equity investments. Thus, the certification hypothesis supports

higher IPO offer prices and reduced underpricing. In contrast, the investor conflict of interest hypothesis

predicts that rational investors demand offer price discounts or greater IPO underpricing as a result of

conflicts of interest created by underwriter share ownership. The alignment of interest hypothesis predicts

that prior equity investments in issuers by oligopolistic underwriters creates an incentive for the

underwriters to minimize the dilution of their equity investments by setting relatively higher offer prices

or by offering smaller underpricing.

We next evaluate the predictions of our three hypotheses for (absolute) IPO price revisions. The

revision of the offer price from the midpoint of the filing range captures information produced by

underwriters’ continued due diligence investigations and book building activities, as well as changes in

market conditions. However, Hanley (1993) documents that IPO offer prices relative to initial filing

ranges only partially adjust to new information. The certification hypothesis posits an information

advantage for underwriters who are prior issuer investors and predicts that underwriter-shareholders

exhibit smaller absolute price revisions; it has no predictions about price revisions.

Under the conflict of interest hypothesis, underwriter-shareholders have incentives to underwrite

riskier and financially weaker IPOs, which raises the likelihood of significant new information being

released after a filing and thus predicts larger absolute price revisions. The conflict of interest hypothesis

also predicts that underwriter-shareholders have incentives to make larger positive price revisions for

positive information released after IPO filing dates, and likewise, to make smaller negative price revisions

for negative news over the same period. Thus, a positive price revision effect is also predicted.

8 Evidence that underwriters set IPO prices substantially below market clearing prices in the 1999-2000 bubble period is reported by Cliff and Denis (2004), Ljungqvist and Wilhelm (2003), and Loughran and Ritter (2004).

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The alignment of interest hypothesis predicts that underwriter-shareholders have incentives to

react more favorably to positive news and less unfavorably to negative news uncovered after the filing

date. Other underwriters underreact on average to new information as documented in Hanley (1993).

Thus, the alignment of interest hypothesis predicts underwriter shareholdings have a positive effect on

price revisions, but not necessarily on its absolute value.

The impact of underwriter shareholdings on gross spread, or underwriter compensation, offers an

alternative avenue for testing our hypotheses. The certification hypothesis predicts that underwriters with

superior issuer information have lower due diligence costs, which lowers gross spreads in a competitive

underwriting market. However, Puri (1999) argues that in an oligopolistic underwriting market, more

credible underwriter-shareholders will seek rents in the form of higher underwriting fees. The alignment

of interest hypothesis predicts a negative relation between underwriter shareholdings and gross spread.

Since the gross spread is an issuer expense, it reduces issuer equity value by a similar amount. Thus,

underwriter-shareholders face a trade-off between the gains they realize from higher fees, which depends

on their relative share of syndicate revenues, and the loss in the value of their shares due to the higher

fees, which depends on their percentage ownership in firm shares. When their shareholdings are small

and their relative shares of the syndicate revenues are large, they have a stronger incentive to raise fees.

Likewise, when their shareholdings are large and their relative shares of the syndicate revenues are small,

they have a stronger incentive to reduce fees.

Lastly, we examine IPO stock long-run performance over the subsequent three and five years,

conditional on the underwriter share ownership level.9 The certification hypothesis predicts a lower

delisting frequency and higher market-to-book ratios for IPOs with underwriter shareholdings due to their

superior information as a private investor. However, superior issuer information allows underwriter-

shareholders to profitably underwrite riskier IPOs, which other underwriters would reject as unprofitable.

As a result, the overall delisting rates and market-to-book ratios of underwriter-shareholders can be

9 Examining stock delistings and market-to-book ratios have the advantage of not requiring estimates of long-run abnormal stock price performance, which are highly sensitive to the benchmarks used. Fama (1998), Eckbo, Masulis, and Norli (2000), and Mitchell and Stafford (2000) discuss various concerns related to the use of long-run benchmarks.

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similar to other underwriters, even though they are taking on riskier IPOs. Consistent with underwriter-

shareholders accepting riskier issues, the average stock return standard deviation is higher for the

underwriter-shareholder IPO sample, as seen in Table 3. Thus, the certification hypothesis does not

necessarily predict a lower delisting frequency and a higher market-to-book ratio. The alignment of

interest hypothesis does not make any predictions about underwriter shareholdings affecting either the

frequency of delisting or the market-to-book ratio. In contrast, the investor conflict of interest hypothesis

predicts a higher delisting rate and a lower market-to-book ratio for IPOs with underwriter-shareholders,

due to underwriters’ lower origination standards. A summary of the predictions for the three hypotheses

is found in Table 1.

Early evidence on the effects of underwriter shareholdings is reported in Gompers and Lerner

(1999) who examine venture-backed IPOs in the U.S. over the 1972-1992 period. They find no significant

relation between IPO underpricing and an indicator of underwriter share ownership. Nonetheless, they

argue that there is evidence of an investor conflict of interest effect since underwriter ownership generally

increases underpricing, even if it is statistically insignificant. Gompers and Lerner (1999) find that when

underwriters are issuer shareholders, IPO excess returns are positive and marginally significant over the

subsequent five years, but the probabilities of issuer bankruptcy and liquidation probabilities are

unaffected. Ljungqvist and Wilhelm (2003) examine the causes of U.S. IPO underpricing and include

prior equity investments by venture capital funds and investment banks as separate regressors.10 They

find that both types of investments are associated with reduced underpricing, though when they introduce

an interaction term between investment bank shareholdings and an underwriter indicator, the parameter

estimate is statistically insignificant.11 Thus, prior research finds that underwriter shareholdings have an

insignificant effect on IPO pricing decisions.12

Our paper is also related to the evidence on bond underwriting that focuses on issue pricing and

quality when a prior lending relationship exists. U.S. evidence indicates a dominant certification role for

10 Ljungqvist and Wilhelm measure equity ownership by investment banks, rather than by underwriters. 11 Our different results may be due to our distinguishing between lead and nonlead underwriter-shareholders and the fact that their sample includes a large number of non-venture-backed IPOs. Thus, there is a much larger proportion of zeros in their interaction term, which lowers its power to detect differences in the venture-backed sample.

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underwriters that have prior banking relationships with issuers [see, for example, Ang and Richardson

(1994), Gande, Puri, Saunders, and Walter (1997), Kroszner and Rajan (1994), Puri (1994), and Puri

(1996), Schenone (2004), and Yasuda (2003)].13 Overall, this body of evidence is consistent with bank

underwriters attracting or selecting higher quality issues.

3. Data Sources and Descriptive Statistics

We focus on the 1993-2000 period given it is associated with a large number of IPO underwriters

with venture capital investments and the relative stability of National Associate of Securities Dealers

(NASD) rules regarding IPO underwriting procedures when underwriters have prior holdings of issuer

securities. To obtain our sample, we identify 1,500 venture-backed IPOs from Securities Data

Corporation’s (SDC) Corporate New Issue Database, after excluding unit offers, closed-end funds

(including REITs), ADRs, limited partnerships, reverse LBOs, equity carve-outs, foreign issues, and IPOs

with offer prices below $5. We obtain prospectuses for all 1500 IPOs and verify that they are venture-

backed by reading the “Principal Shareholder” and “Underwriting” sections of each prospectus. Twenty

IPOs that SDC designated as having venture investors are excluded when the IPO prospectus makes no

such mention of venture investment, leaving a final sample of 1480 venture-backed IPOs.

Detailed underwriter ownership information is obtained from IPO prospectuses. Underwriters

typically disclose their pre-IPO equity ownership in the “Underwriting” section of the prospectus, though

we also search in the “Principal Shareholder” section. We use Pratt’s Gruide to Venture Capital Sources,

the VentureXpert database, and VC websites to confirm the underwriter-affiliated VC funds. Underwriter

share ownership includes ownership by bank managers or their subsidiaries such as a captive venture

capital funds.

Issuer warrant ownership by underwriters is obtained from IPO prospectuses. Since very few

nonlead underwriters own warrants in IPO firms, we only examine the 102 IPOs which have lead

12 Hamao, Packer, and Ritter (2000) and Klein and Zoeller (2001) report evidence on IPOs in foreign markets. 13 Hamao and Hoshi (1999) find that Japanese bond issues brought to market by commercial banks have lower offer prices than those of other issues, suggesting greater concern about underwriter conflicts of interest with IPO investors.

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underwriters warrant holdings.14 Pre- and post-IPO shares outstanding, syndicate size, percentage of

secondary shares offered, total assets, and property, plant, and equipment are also collected from the

prospectuses. Stock capitalization, stock closing prices, bid and ask quotes, industry classification codes,

stock return standard deviation over event days +21 through +270, delisting information, and market

returns over event days –60 through -1 are obtained from the University of Chicago’s Center for Research

in Securities Prices (CRSP). Book value of total assets, common stock outstanding, deferred taxes, and

SIC codes are obtained from the Compustat annual financial reporting files. The IPO filing price range,

initial filing date, and simultaneous global offerings are taken from Thomson Financial’s SDC New

Issues database. Underwriter reputation, industry classifications for Internet and technology industries,

incorporation dates, and the total number of IPOs over the prior three months are obtained from Jay

Ritter’s website. Information on VC age at the IPO is taken from VentureXpert and is supplemented by

IPO prospectuses when missing from SDC.

Table 2 presents descriptive information for the final sample. The sample has the largest number

of IPOs in 1999 and the least in 1998. Years 1993, 1996, and 2000 also have large numbers of IPOs.

Among venture-backed IPOs, we find underwriter shareholdings in 484 issues and lead underwriter

shareholdings in 298 issues. The fraction of venture-backed IPOs with prior underwriter ownership by

year ranges from 18% to 41% across the eight-year sample period, with an upward trend. The lead

underwriters tend to make roughly half of those investments. Table 2 Panel B examines the sample of

IPOs with underwriter shareholdings by year and finds that mean percentage shareholdings fall from 19%

to 9% over the sample period.

Table 3 presents descriptive statistics for our venture-backed IPO sample by issue characteristics

and our dependent variables (underpricing, price revisions, gross spreads, number of delistings, and

market-to-book ratios). IPOs are classified by underwriter share ownership. Comparing the second and

third columns, we find that IPOs with underwriter venture investments in issuer stock have greater

14 Warrants are often awarded as added compensation, in which case we treat the lead underwriters as the owners.

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underpricing, price revisions, delisting rates, and market-to-book ratios after five years. Underwriter

gross spreads and market-to-book ratios after three years are slightly lower for underwriter-shareholders.

4. Empirical Results on IPO Pricing

4.1. IPO Underpricing

We begin the analysis by examining the predictions of our three hypotheses for IPO underpricing

when underwriters have pre-IPO shareholdings. Under the investor conflict of interest hypothesis,

underwriter shareholdings are predicted to increase underpricing; under the issuer alignment of interest

hypothesis, they are predicted to lower underpricing; and under the certification hypothesis, they are

predicted to lower underpricing.

Underwriter shareholdings can be measured qualitatively by an indicator, as in Gompers and

Lerner (1999), or can be measured quantitatively on either a dollar basis or a percentage basis.

Quantitative metrics could be important if underwriters often have very small shareholdings with

negligible incentive effects, in which case, a qualitative measure of underwriter ownership has low power

to detect underwriter shareholding effects. In this study, the primary measure of underwriter ownership is

pre-IPO shareholdings as a percentage of pre-IPO issuer shares outstanding. IPO underpricing is

measured by the initial closing price minus the offer price divided by the offer price.

Based on prior research, we employ a broad set of control variables in testing the significance of

underwriter shareholdings on IPO underpricing. These control variables are: management ownership, VC

ownership, underwriter warrant ownership, proportion of tangible assets, firm and offer size, percentage

increase in shares (see Krasker (1986)), prior market return, filing date to IPO interval, underwriter

reputation, a global offering indicator, and an Internet indicator. Most of these control variables have

been used in earlier IPO underpricing studies by Cliff and Dennis (2004), Gompers and Lerner (1999),

Lee and Wahal (2004), Ljungqvist and Wilhelm (2003), Loughran and Ritter (2004), and Schenone

(2004).

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To test the conjecture that measuring the effects of underwriter share ownership by an indicator

variable has low power to detect an effect on underpricing, we replicate the basic equation in Gompers

and Lerner’s study of 1972-1992 IPOs, with our more recent 1993-2000 IPO sample. Using a more

extensive set of issue characteristics as control variables, we find a statistically insignificant relationship

in unreported results, confirming the earlier Gompers and Lerner evidence. We conjecture that their

insignificant result is due to IPOs with small underwriter ownership. We test this conjecture by redefining

the indicator to equal one only when underwriter ownership exceeds a threshold level. We find that the

coefficients for the lead and nonlead indicators become significant only when we raise the threshold to

7.5%. This is consistent with our theory as to why they find a weaker relation. A more interesting

question is whether this relation is statistically and economically insignificant when we fully exploit

information about the magnitude of the shareholdings. We pursue this question in the following analysis.

Table 4 reports ordinary least square (OLS) estimates of the effects of underwriter venture

investments on underpricing. In the first column, we find that prior underwriter share ownership

significantly reduces IPO underpricing. The coefficient estimate is -0.71, while we know from Table 2

that average underwriter stock ownership is 11% and average underpricing is 39.4%. Thus, average

underwriter ownership is associated with a 7.8% drop in underpricing, which represents a 19.8%

reduction in mean IPO underpricing. This evidence differs from the insignificant underwriter ownership

effect reported by Gompers and Lerner (1999) and is consistent with our conjecture that the indicator

variable for underwriter ownership has low power. When lead and nonlead ownership are separated in

the second regression, we find that lead underwriter ownership is associated with a larger reduction in

underpricing and greater statistical significance. This suggests that lead underwriter share ownership has a

stronger effect than the nonlead underwriter shareholdings.15 The adjusted R-square of 33% indicates that

issue characteristics used in the model explain a large portion of the cross-sectional variability in IPO

returns.

15 We also experiment with squared ownership to capture nonlinearity, but we find insignificant effects.

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Puri (1999) predicts a positive certification effect on underpricing when there is underwriter

ownership. She also observes that as underwriters’ investments in the issuer increase, so do their

incentives to underwrite weak issues. By underwriting an equity offering, the issuer’s financial condition

is strengthened and this gives the underwriters time to sell their shares in the secondary market following

the IPO, thereby avoiding large losses. The significant negative effect of underwriter shareholdings on

underpricing suggests that a positive certification effect dominates any investor conflict of interest effect

in our IPO sample. Alternatively, this result can be interpreted as support for greater underwriter

alignment of interests with issuers, assuming underwriters have some pricing power.

Puri observes that a positive conflict of interest effect on underpricing is more likely as

underwriter stock holdings become large. However, this effect is caused by underwriters being able to

quickly sell their shares following IPOs. Their ability to quickly exit the stock is eliminated under a

conventional IPO lock-up clause that contractually binds underwriters to retain their shares for an

extended period, typically six months following the IPO. The fact that our evidence does not support a

dominant IPO investor conflict of interest effect suggests that a lock-up clause is an effective mechanism

for protecting IPO investors from an underwriter moral hazard problem. In addition, subsequent sales of

stock by underwriters can be further limited by SEC disclosure regulations and NASD Rule 2710, which

tightly restricts subsequent sales of stock by underwriters and venture capital investors.16

Earlier studies by Ljungqvist and Wilhelm (2003) and Loughran and Ritter (2004) report large

increases in IPO underpricing in the 1999-2000 “bubble” period. This raises questions as to whether or

not our results are driven by potentially anomalous results from this period, a period characterized by

analysts hyping technology stocks and some underwriters allocating issues to investors who promise to

buy additional shares in the secondary market, thereby causing naïve retail investors to be highly

optimistic about IPO prospects. To assess the robustness of our results, we break the sample into a 1993-

1998 pre-bubble period and a 1999-2000 bubble period to assess whether our findings are qualitatively

the same across the two subperiods. Columns (3) and (4) of Table 4 show that both lead and nonlead

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underwriter ownership significantly reduce underpricing. Thus, the qualitative results are very similar for

both the pre-bubble and bubble periods. Quantitatively, there are some interesting differences. In the

pre-bubble period, lead shareholdings are associated with a slightly larger reduction in underpricing than

nonleads. However, in the 1999-2000 period, nonlead shareholdings are associated with twice the

reduction in underpricing as those of the leads. In addition, the impact of underwriter shareholdings on

underpricing is much greater in the bubble period than in the non-bubble period, especially for nonlead

underwriters. This result should not be surprising given the much higher mean level of underpricing in the

bubble period.

If underwriter ownership serves as a certification device in IPOs, then the certification benefit

should be stronger for IPO issuers with greater investor uncertainty. To further test the certification and

conflicts of interest hypotheses, we use aftermarket stock return variance measured over trading days +21

to +270 as a proxy for investor uncertainty about IPO valuation, based on earlier work by Beatty and

Ritter (1986). Investors in high return variance IPOs are likely to face more information asymmetry and

as a consequence underwriter certification should be more important. In column (5) of Table 4, we

effectively split the IPO sample into high and low stock return variance subsamples defined by median

variance value. We accomplish this by interacting high and low return variance stock indicators with lead

and nonlead underwriter shareholdings. We find that lead and nonlead ownership reduces underpricing

significantly for both high and low variance issuers. However, the statistical significance of lead and

nonlead shareholdings is nearly twice as great for high variance issuers relative to low variance issuers.

We obtain virtually identical results with alternative measures of information asymmetry, such as the

proportion of tangible assets or residual return variance, calculated from a one-factor market model based

on the CRSP value-weighted market index for the IPO’s exchange.

In examining the control variable estimates in Table 4, we see that underwriter warrant

ownership, offer size, prior market return, and global offering and Internet indicators all have positive and

statistically significant effects on underpricing, while VC ownership, tangible assets, total assets,

16 General partners in these funds are restricted as long as they hold a board seat. However, VC funds can distribute

15

percentage of shares offered, and days between filing date and IPO have significantly negative effects on

underpricing. The positive effects of global offering and Internet indicators on IPO underpricing are

consistent with both global offers and firms with high levels of growth opportunities and intangible assets

having larger pricing uncertainty and adverse selection effects. The positive effect of prior market return

is consistent with prior IPO studies such as Hanley (1993) and Lowry and Schwert (2004), which find a

partial adjustment of IPO offer prices to positive issue information uncovered after the initial filings. The

negative effect of total assets is consistent with issuers with more geographic and industry diversification

having less price uncertainty. Similarly, the negative effect of tangible assets is consistent with firms with

larger proportions of tangible assets having less price uncertainty.

4.2. Adjusting for Price Stabilization Effects

Several recent studies of price stabilizations by Aggarwal (2000), Ellis, Michaely, and O’Hara

(2000), and Lewellen (2003) document that IPO stock prices are artificially raised by underwriters closing

short positions associated with overselling an IPO issue. Underwriters hold overallotment options granted

by issuers that give underwriters the right to purchase an additional 15% above the original offer size.

These options allow underwriters to oversell or short sell IPO issues to investors by 15% without taking

any further risk. Overallotment options are then used to cover an underwriter’s short position, when the

aftermarket reception for the issue is strong. For weak issues, the underwriter forgoes exercising the

options and instead buys the stock in the secondary market, typically at a price near the offering price.

This stabilization activity tends to be concentrated in stocks that receive weak market reception and

usually occurs over the initial week or two of trading. Lewellen documents that stabilization induces

significant price rigidity at or below the offer price and raises the equilibrium stock price in the short run.

This raises a concern as to whether our analysis of IPO underpricing is unduly biased by this stabilization

activity.

shares to limited partners, who are not constrained from selling by insider trading regulations.

16

Unfortunately, direct information on most underwriter stabilization activity is unavailable. Thus,

researchers are forced to use proxies to capture this effect. However, using data on underwriter price

stabilization activity, Aggarwal documents that IPOs with weak initial returns of 5% or less exhibit a

disproportionately large amount of price stabilization activity. Aggarwal also finds that 84% of IPOs

with offer prices below their filing ranges have short covering price stabilization. She also finds that IPOs

for which little of the 15% underwriter’s overallotment option is exercised have a high frequency of short

covering stabilization activity. Other earlier studies on stabilization commonly use initial IPO returns

equal to zero as a proxy for stabilization.

To investigate the sensitivity of our underpricing evidence to price stabilization activity, we use

several alternative proxies for stabilization, including initial returns of 5% or less, initial IPO returns

equal to zero, and IPOs with offer prices below their initial filing ranges. Reestimating regressions (1)

and (2) of Table 4 after excluding all IPOs with initial returns of 5% or less, we find that our prior results

are strengthened with respect to statistical significance of the coefficient on underwriter shareholdings.

More specifically, we find that the coefficients for shareholdings of underwriters, lead underwriters, and

nonlead underwriters are all negative and significant with t-statistics of -5.61, -4.86, and -3.74,

respectively. We find qualitatively similar results when we exclude IPOs with initial returns of zero or

offer prices below the filing range. Thus, our evidence does not appear to be caused by price stabilization,

though it does appear to cloud a portion of the underwriter shareholding effect.17

4.3. Controlling for Endogeneity

If factors that cause a bank to underwrite a particular IPO also cause the same bank to make a

prior venture investment in an issuer, this would generate a potential selection bias and result in

inconsistent model estimates. To address our selection bias concern, we use a variation on the Heckman

(1979) correction procedure [see Lee, Maddala, and Trost (1980) and Greene (1997)]. Since an

underwriter’s percentage equity investment in an issuer (UPCT) is constrained to lie between zero and

17

one, we model an underwriter’s likelihood of making a venture investment, UPCT, as a two-boundary

Tobit variable:

* '

*

* *

*

(1 )

100 100 (1 )

0 100 (1 )

0 0 (1 )

i i i i

i

i i i

i

UPCT M b a

when UPCT b

UPCT UPCT when UPCT c

when UPCT d

ε= +

≤

= < ≤ ≤

where UPCT* is a latent variable observed only when underwriters make a venture investment and Mi

represents a vector of determinants of underwriters’ prior venture investments. The first-step model

estimates the likelihood of underwriters making venture investments in these privately held firms. In the

second-step linear regression, we add Lambda, the inverse Mills ratio, from the first-step Tobit model

estimation as an additional regressor:

First Step: 0 1( ) *Tobit UPCT a a Control Variables ε= + ⋅ + (2a)

Second Step: 0 1 2 3Underpricing a a UPCT a Control Variables a Lambda ε= + ⋅ + ⋅ + + (2b)

Table 5 reports the results of controlling for selection bias on the relation between underwriter

shareholdings and IPO underpricing. The first-step estimates a predictive model for lead and nonlead

underwriter venture investment in our sample of privately held firms, as shown in columns (1) and (2) of

Table 5. We base this model on prior work on VC investment activity. It is well documented that

individual VCs specialize in a few promising industries or technologies.18 As recent entrants into the VC

industry, commercial banks are also likely to follow different strategies from traditional VCs to capture

market share, as argued by Gande, Puri, and Saunders (1999) and Chaplinski and Erwin (2001).

Megginson and Weiss (1991) argue that VC reputation should also affect IPO underpricing, potentially

due to the higher standards they use in choosing which investments they make. Gompers and Lerner

(1999) and Lee and Wahal (2004) use VC age as a proxy for VC reputation and report that young VCs are

much more apt to take firms public early. To capture these relations, our Tobit model includes indicators

17 The earlier inconclusive evidence in Gompers and Lerner could also be due to price stabilization activities that cloud the effect of shareholder ownership on underpricing. 18 See, for example, Fenn, Liang, and Prowse (1997) and Zider (1998).

18

for Internet and technology companies, bank underwriters, firm age, and lead VC age to help predict

whether potential underwriters would make venture capital investments in our sample of privately held

firms.19 These explanatory variables use firm characteristics and underwriter characteristics known at the

time of an underwriter’s initial VC investment.

The first two columns of Table 5 indicate that lead underwriter venture investment is significantly

related to firm age, and Section 20 subsidiary and technology indicators. Examining nonlead

underwriters, we find that Internet and Section 20 indicators are statistically significant. The pseudo R-

square is 8% and 9% in the first-step model for lead and nonlead underwriters, respectively. For the

second-step model, the estimates presented in columns (3) and (4) of Table 5 indicate very similar results

to those reported in Table 4. The inverse Mills ratios derived from the first-step estimation are

insignificant. In summary, our results do not appear to be caused by selection bias associated with an

underwriter’s choice of venture investment.

4.4. Other Sensitivity Tests

In unreported results, we subdivide the IPO sample by whether the lead underwriter is a

commercial bank (a Section 20 subsidiary) or an investment bank. We find that underwriter share

ownership significantly reduces IPO underpricing, regardless of whether the underwriter is a commercial

bank or not. When we further decompose underwriters into leads and other syndicate members, we find

that both lead and nonlead investment bank shareholders significantly reduce underpricing at the 5%

level, while both lead and nonlead commercial bank shareholders reduce underpricing at the 10% level,

which may reflect the much smaller commercial bank sample size.

In further sensitivity analysis, we explore the robustness of our initial findings to several

alternative measures of underpricing and underwriter share ownership. We first examine whether our

results are sensitive to replacing one-day IPO returns with five-day returns as the dependent variable. We

also examine initial ten- and twenty-day IPO returns, but do not present these results since they are

19 A lead VC is defined as the VC with the largest stockholdings pre-IPO. In the vast majority of the cases, that

19

qualitatively similar to the one-day returns. We also re-estimate the earlier regressions when one-day IPO

returns are based on the midpoints of closing bid and ask quotes, instead of closing prices. This

procedure extracts any bid-ask bounce effect from initial IPO returns, an effect which Lease, Masulis, and

Page (1991) find represents a significant portion of public offering date returns for seasoned equity offers.

We find that the bid-ask bounce effect has little impact on initial IPO returns and our earlier underpricing

results are insensitive to this adjustment. Next, we substitute underwriter dollar ownership in place of

underwriter percentage ownership and find that our primary conclusions are qualitatively unchanged,

though the significance of the results noticeably weakens. Overall, we find our results are robust to the

inclusion of a number of alternative control variables that further describe the issue.20

Finally, we investigate the impact of NASD regulation, which requires the use of a qualified

independent underwriter (QIU) under certain conditions. Issued in 1971 to mitigate the conflicts of

interest between IPO investors and underwriters, NASD Rule 2720 defines a QIU as a syndicate member

with 5% or less investment in an issuer’s securities. This rule requires a QIU to undertake a due diligence

analysis and set a maximum offer price when one or more underwriters in the syndicate has an investment

of 10% or greater in an issuer’s debt or equity.21 When a QIU indicator is added as a new control variable

in the statistical model for each of our dependent variables, we find that it is statistically insignificant.

This evidence suggests that the QIU mechanism is ineffective at protecting IPO investors.

5. IPO Price Revisions and Prior Underwriter Shareholdings

We turn next to test the predictions of our hypotheses for price revisions, defined as the offer

price minus the filing price range midpoint scaled by the same midpoint. While the filing price range is a

mechanical function of its midpoint, the filing price range does reflect an underwriter's due diligence

would correspond to the VC with the largest investment. 20 Other control variables examined include post-IPO share trading volume and stock return standard deviations, average underpricing of IPOs over the prior three months, a financial industry indicator, a Section 20 bank indicator, a QIU indicator, and the log of property, plant and equipment (PPE). Of these variables only trading volume is significant. 21 Rule 2720 presumes conflicts of interest exist if underwriters own 10% or more of an issuer’s securities, i.e. common equity, preferred equity, or subordinated debt. In our sample period, a QIU must be a syndicate member that owns less than 5% of the issuer’s voting securities. This rule is unchanged over our sample period.

20

investigation of an issuer. IPO price revisions from the filing range midpoints capture a portion of the

information produced by underwriters’ continued due diligence investigations, book building activities, as

well as updates on market conditions. Given positive information releases are more likely prior to

completed IPOs, we expect to observe on average positive price revisions in our IPO sample.

Under the certification hypothesis, underwriter-shareholders have superior information about

issuers, which leads to more accurate due diligence investigations and filing range prices. Thus,

uncovering new information between filing and offer dates is less likely, resulting in a negative relation

between shareholdings and price revisions or their absolute values. In contrast, the investor conflict of

interest hypothesis predicts that underwriter-shareholders have incentives to underwrite riskier and

financially weaker IPOs. This leads to a greater likelihood of information being released after the filing

date, and thus to a predicted positive relation with absolute price revisions. These underwriters also have

incentives to emphasize positive news and discount negative news in the intervening period, thereby

leading to a prediction of a positive relation with price revisions. Finally, the alignment of interest

hypothesis predicts a positive relation between underwriter shareholdings and price revisions, following

along the lines of the prior hypothesis.

Table 6 presents evidence on the relation between underwriter venture investments in issuers and

either percentage offer price revisions or their absolute values. Because other issue characteristics can

differ across IPOs and these differences can affect the likelihood of new information being released

between the filing and offer dates, we need to control for a number of issue characteristics in our price

revisions regressions. A number of our control variables are similar to those used by Ljungqvist and

Wilhelm (2003) to study price revisions.

The first regression in Table 6 estimates the underwriter shareholding effect on absolute price

revisions.22 We see that both lead and nonlead underwriter shareholdings significantly reduce absolute

price revisions based on OLS estimates. However, the size and statistical significance of lead underwriter

22 Since absolute price revisions are potentially skewed, we also transform the dependent variable by taking natural logarithms of one plus the absolute price revisions before estimating OLS regression. We add one before taking logs to avoid losing observations where the offer price equals the filing range midpoint.

21

ownership is substantially greater. This evidence supports the certification hypothesis prediction that

underwriter-venture investors have smaller absolute price revisions from initial filing range midpoints.

The negative relation between lead underwriter ownership and absolute price revisions supports the

prediction that lead underwriters with venture investments have better access to issuer specific

information, which they use to set IPO filing ranges. In contrast, the prediction of the investor conflict of

interest hypothesis appears inconsistent with evidence. Looking at the remaining coefficient estimates,

we see that a large majority of the explanatory variables have significant coefficients and the explanatory

power of the cross-sectional model is substantial, based on an adjusted R-square of 18%.

The second regression in Table 6 estimates the effects of underwriter ownership on price

revisions. The evidence indicates that both lead and nonlead underwriter shareholdings significantly

reduce price revisions. Moreover, the size and statistical significance of lead underwriter ownership is

substantially greater than for nonlead share ownership. This evidence is inconsistent with the investor

conflict of interest and alignment of interest hypotheses.

The overall explanatory power of the price revision regression is substantial, as indicated by an

adjusted R-square of 40%. In addition, nearly all of the control variables have statistically significant

effects. Specifically, issues involving larger VC ownership, total assets, and tangible assets have smaller

price revisions, while global offers, offers with a larger dollar value, and offers in technology (Internet)

industries have smaller (greater) price revisions. Stronger prior market conditions decrease price

revisions. These results are consistent with more risky issues having greater price revisions. Warrant

holdings by lead underwriters also significantly increase price revisions. This result is consistent with

warrant compensation being associated with riskier IPOs, which have a greater likelihood of important

information releases after the initial filing date. Larger IPOs tend to have lower price revisions, which is

consistent with underwriters being motivated to undertake more extensive due diligence investigations as

their exposure to underwriting losses rises. Larger prior market returns are associated with larger price

22

revisions, which is consistent with offer prices only partially adjusting to new information uncovered after

the filing date.23

In unreported results, we assess the robustness of the above results. First, we interact lead

shareholdings with the high and low asymmetric information indicators. We find that the high asymmetric

information IPOs with lead underwriter shareholdings experience significant reductions in price revisions,

and to a lesser extent in their absolute values. Low asymmetric information IPOs with lead shareholdings

also experience reduced price revisions and absolute price revisions, but only the coefficient of absolute

price revisions is significant. Second, we divide the IPO sample into both pre-bubble and bubble periods

and investment bank and commercial bank (Section 20 subsidiaries) underwriters, and find qualitatively

similar results for all four subsamples. We also exclude IPOs that are likely to have underwriter price

stabilization, since this would tend to reduce the size of price revisions. To assess the impact of

stabilization activities, we again exclude IPOs with initial returns of 5% or less. When we re-estimate

these regressions, we find negligible changes in the statistical significance of underwriter shareholdings

for both price revisions and their absolute values, indicating that price stabilization does not bias our prior

results.

6. Underwriter Spreads and Prior Underwriter Shareholdings

We next examine the impact of prior underwriter shareholdings on direct underwriter

compensation, or gross spread, and its three major components. The certification hypothesis predicts that

underwriters with superior issuer information have lower due diligence costs, which lowers gross spreads

in a competitive underwriting market. However, Puri (1999) argues that in an oligopolistic underwriting

market, more credible underwriter-shareholders will seek rents in the form of higher underwriting fees.

Under the alignment of interest hypothesis, we expect underwriter-shareholders to offer lower spreads,

and the lead underwriter may have more power to reduce fees. Finally, the conflict of interest hypothesis

makes no predictions about gross spread.

23 We also examine the effect of a QIU and find insignificant effects for price revisions and absolute price revisions.

23

Although a large majority of gross spreads are at 7%, substantial variation remains especially for

the relatively larger and smaller IPOs.24 In addition, when we decompose gross spread into its three

major components; namely management fees, underwriting fees, and selling concessions, we find much

greater variability across its three components. Management fees are compensation to the book manager

for its due diligence efforts, negotiation costs and syndicate coordination costs. Underwriting fees are

compensation for syndicate commitments to buy entire offerings at fixed prices. Finally, selling

concessions are compensation given to selling syndicate members who do not necessarily bear any

underwriting risk, but do commit to help retail the issue. We examine all four underwriter expense

measures, since different syndicate members, especially syndicate leads, can have relatively more

influence over some components of spread than others. Because these four underwriter compensation

measures are all fractions between zero and one, we use a logistic regression that has attractive statistical

properties when the dependent variable is a proportion.

Since the dependent variables are constrained to be positive fractions by definition, we use a

logistic regression model in our investigation. Table 7 presents estimates from a logistic regression

measuring the impacts of underwriter shareholdings on gross spread and its components. Column (1)

shows the estimated effects on gross spread of underwriter shareholdings and other control variables. We

find that of underwriter venture investments, only lead underwriter investments have a significant effect,

and the sign is negative. The sign of the underwriter ownership coefficient is consistent with Gande et al.

(1997), although they do not find the reduction in gross spread when Section 20 bank subsidiaries

underwrite debt offerings to be significant.

The significant lead underwriter effect is consistent with the predictions of the certification

hypothesis in a competitive underwriting market. It is also consistent with the issuer alignment of interest

hypothesis in an oligopolistic underwriting market, which predicts that underwriter-shareholders charge

24 Chen and Ritter (2000) draw this conclusion, though Hansen (2001) argues that this is driven by the sampling criteria and that a 7% fee is much less common for the population of IPOs than suggested by Chen and Ritter. We find for our sample that 7.3% have gross spreads below 7% and another 7.3% have gross spreads above 7%.

24

lower gross spreads. Our evidence is not supportive of Puri (1999), who predicts that underwriters with

pricing power charge higher underwriting fees when they have better certification ability.

Turning to the control variables, our choice reflects the earlier studies of gross spreads by

Altinkilic and Hansen (2000), Eckbo and Masulis (1995), and Hansen (2001),25 who find that total assets,

offer size, percentage change in outstanding shares, and return volatility are significantly related to gross

spreads. Examining the estimated coefficients for our control variables, we see that lead underwriter

warrant ownership is significantly positively related to gross spread. This result is consistent with

warrant ownership being a proxy for weaker issues, which are only underwritten at higher levels of

compensation that are paid in warrants. Turning to the control variables, we see that the tangible assets,

total assets, offer size, and issuer age are negatively related to gross spread. Underwriter reputation is

also associated with significantly lower spreads, which is inconsistent with Puri’s prediction that higher

quality underwriters charge higher fees. One potential explanation for this finding is that higher quality

bankers underwrite better quality issues as predicted by Fernando, Gatchev, and Spindt (2003). Finally,

both the global offering and bubble period indicators, and recent stock market gains are associated with

significantly higher spreads. The pseudo R-square of 0.48 indicates that the model has a high level of

explanatory power.

The remaining three columns in Table 7 present logisitic model estimates of the underwriter

shareholding relationships with the three main components of gross spread. The evidence indicates that

the primary impact of the lead underwriter shareholdings is in reducing management fees. Nonlead

shareholdings have no significant effects on any of the fee components. While lead underwriter

shareholdings reduces all three gross spread components, it only significantly reduces management fees,

which is consistent with the lead having the most influence over how its own compensation is set. 26

Because of limited cross-sectional variations in gross spreads, we also estimate an ordered probit

model as a robustness check, where the dependent indicator variable equals zero if the gross spread is less

25 Note that Eckbo and Masulis (1995) examine seasoned equity offers. 26 We also examine the effects of breaking up the sample into both pre-bubble and bubble periods and investment bank and commercial bank (Section 20 subsidiaries) underwriters. We also use the same first-step model to test for selection bias in offer price revisions and gross spreads. Our basic results are robust to these adjustments.

25

than 7%, one if it is exactly 7%, and two if it is more than 7%. In unreported results, the estimated

ordered probit model shows that gross spread is again significantly negatively related to lead underwriter

shareholdings and that it exhibits economics of scale.27 In other unreported results, we interact lead

underwriter shareholdings with high and low asymmetric information indicators and find that only the

interaction term with high asymmetric information IPOs significantly reduces gross spread (at the 10%

level). This is consistent with improved due diligence under the certification hypothesis, which reduces

underwriter expected losses and leads to lower gross spreads.

The underwriter fee evidence yields the following conclusions. Lead underwriter share ownership

appears to create a closer alignment of interests between the underwriting syndicate and issuing firm

shareholders. Consistent with an issuer alignment of interest effect, gross spreads are reduced. However,

it is unclear why nonlead underwriter-shareholders do not also lobby the syndicate for lower underwriting

fees. The most likely explanation is that lead underwriters have disproportionately larger decision-making

power in the syndicate.

An alternative interpretation of the negative gross spread effect is that underwriter-shareholders

have greater knowledge of issuers, which lowers the cost of their due diligence examination and

certification of an IPO and reduces associated underwriter risk exposure. This interpretation is also

supported by the fact that lead shareholdings in only high asymmetric information IPOs have a significant

negative effect on gross spread. However, this certification argument does not explain why only lead

underwriters can convey reliable information to syndicate decision makers about an issuer’s financial

condition, especially in the face of repeated relationships among these underwriters, which would allow

deception to be penalized. The certification interpretation also appears inconsistent with the negative, but

marginally insignificant, relation between underwriter shareholdings and the underwriting fee component

of gross spread.

7. Long-Run Performance Following IPOs

27 The specifications based on Altinkilic-Hansen (2000) yield qualitatively similar results.

26

To further test the predictions of our three competing hypotheses, we examine stock long-run

performance conditional on whether or not an underwriter has prior shareholdings in the issuer. We use

two measures of long-run performance; namely, the frequency of delisting for financial distress and

Tobin’s Q at three and five years following the IPO. Many prior studies employ Tobin’s Q as a measure

of firm performance; see, for example, Yermack (1996), McConnell and Serveas (1990) and Laporta et al.

(2002). Under the underwriter certification hypothesis, we expect lower delisting rates and higher

market-to-book ratios due to underwriters’ superior information as a private equity investor with potential

board representation or observation rights and private access to management. However, this ignores the

underwriter-shareholders’ added incentives to accept more risky issues, which can result in zero long-run

performance. There is no clear prediction about long-run performance under the issuer alignment

hypothesis. In contrast, the investor conflict of interest hypothesis predicts a higher delisting rate and

lower market-to-book ratios for IPOs with underwriter-shareholders, since underwriters have incentives

as shareholders to loosen their underwriting standards so as to sell weaker issuers to the public at higher

prices, thereby increasing their prior equity investment’s value.28

We estimate the likelihood of delisting using a probit model, where the dependent variable equals

one when the stock is delisted because of financial distress (i.e. does not meet listing requirements) over

the three or five years following the IPO. Information on delisting dates and reasons for delisting are

taken from the CRSP Daily Stock Price database. Since our sample period ends in 2003, we lose bubble

period IPOs when we shift from a three-year to a five-year delisting horizon. All 1,480 IPOs in our

sample have at least three years of seasoning by year-end 2003. However, only 984 IPOs have five years

of seasoning by year-end 2003. Over these same three- and five-year horizons, we find only 122 and 124

IPOs in our sample are delisted due to financial deterioration, defined as CRSP delisting codes between

500 and 600. In addition, only two companies in our sample are liquidated within three (or five) years of

their IPO dates. 29

28 A number of earlier studies use the market-to-book ratio to proxy for Tobin’s Q and a firm’s long-run performance; see, for example, Kaplan and Zingales (1997). 29 The two liquidated IPOs have a CRSP delisting code of 480.

27

Probit estimates of the likelihood of delisting due to financial distress after controlling for IPO

characteristics are presented in the first two columns of Table 8. The explanatory power of the models is

good with pseudo R-squares of about 30%. The coefficient estimates show that the likelihood of delisting

rises with price volatility, recent IPO activity, and if the issuer is an Internet company. It is also

positively related to issuer total assets and offer size, which seems somewhat surprising. With respect to

underwriter shareholdings, we find no evidence of a significant relation with subsequent stock delisting.

Gompers and Lerner (1999) report similar evidence for an earlier sample period. This last piece of

evidence is inconsistent with the investor conflict of interest hypothesis, which predicts IPO overpricing

and underwriting of more risky IPOs. The last result weakly supports the certification hypothesis, which

predicts either unchanged or lower delisting rates for underwriters who are also shareholders.

We next examine post-IPO Tobin’s Q values, measured by market-to-book ratios at the end of

years three and five following the IPO. Following Kaplan and Zingales (1997), the market-to-book ratio

is measured by the book value of assets plus market value of common stock less book value of common

stock and deferred taxes, all divided by book value of assets. Market values and book values are

measured at the end of the calendar year and the firm’s fiscal year, respectively. We also adjust issuer

market-to-book ratios by industry median market-to-book ratios using the 48 industry classifications

developed by Fama and French (1997) as reported in Ken French’s website. Columns (3) and (4) of

Table 8 present OLS estimates of the relation between market-to-book ratios three and five years after the

IPO and pre-IPO underwriter shareholdings, where we also control for various IPO characteristics.

Heteroscedasticity-consistent standard errors are reported. The models show modest explanatory power

with adjusted R-squares of about 6%. The evidence does not suggest any significant relationship between

underwriter shareholdings and subsequent market-to-book ratios. This evidence is inconsistent with the

investor conflict of interest hypothesis and weakly supportive of the certification hypothesis, similar to

the evidence on delisting probabilities. As a robustness test, we excluded the cases with negative market-

to-book ratios from the analysis and find that the qualitative results are unchanged

28

8. Conclusions

We study the impact of underwriters having prior venture investments in issuers on IPO pricing

and underwriting fees. Since commercial banks can now invest in IPOs through venture capital

subsidiaries, banks that act in the dual capacity of IPO underwriter and private equity investor provide a

unique opportunity for evaluating the joint effects of share ownership and underwriter due diligence and

price setting. The analysis also provides evidence on the determinants of IPO issue costs and the possible

costs and benefits of allowing commercial banks to underwrite equity offers and act as private equity

investors – important questions in the debate over banking reform.

We evaluate three hypotheses related to how underwriter shareholdings affect the IPO process.

Under the investor conflict of interest hypothesis, underwriter shareholdings can exacerbate the conflict of

interest with IPO investors, thereby undermining underwriter credibility and reducing market clearing

offer prices, that is, exhibiting greater underpricing. Under the certification hypothesis, underwriter

shareholdings strengthen the credibility of the underwriter’s due diligence investigation by giving it

access to proprietary issuer information, which raises the prices that IPO investors are willing to pay.

Under the issuer alignment of interest hypothesis, underwriter shareholdings reduce the conflict of interest

between issuer shareholders and their underwriters, who have market power to underprice issues and the

right to allocate underpriced issues to favored customers. Since share price is diluted by lower offer

prices, private equity investments create new incentives for underwriters to set higher IPO offer prices.

To help evaluate the descriptive validity of our three competing hypotheses, we examine their predictions

for five IPO issue characteristics as summarized in Table 1.

We find that underwriters’ prior shareholdings significantly reduce IPO underpricing. This result

holds strongly for lead underwriter ownership and less strongly for nonlead underwriter ownership. The

result is robust to a selection bias adjustment for banks’ venture capital investment criteria. This evidence

supports the certification and issuer alignment of interest hypotheses. In further analysis, the reduction in

underpricing with underwriter shareholdings is greater when IPO stocks have higher price uncertainty.

29

This evidence further supports the certification hypothesis since IPO investors would be expected to place

greater importance on underwriter certification when there is more price uncertainty.

Examining other evidence, we find that when lead underwriters, and to a lesser extent nonlead

underwriters, are IPO shareholders, the offer price adjustments from IPO filing range midpoints tend to be

smaller, as do the absolute values of these price revisions. This effect is primarily associated with high

asymmetric information IPOs. This evidence is consistent with the certification hypothesis, which states

that underwriters have superior information about issuer financial condition and undertake more thorough

and credible due diligence investigations, and that the benefits of certification are greater for IPOs with

high price uncertainty. This evidence is inconsistent with the alignment of interest and investor conflict

of interest hypotheses.

Lead underwriter shareholdings in issuers is also associated with lower underwriting fees and is

concentrated in high asymmetric information IPOs, which is consistent with the certification and

alignment of interest hypotheses. Finally, the lack of any significant relation between underwriter

shareholdings and either the frequency of post-IPO exchange delistings or Tobin’s Q values ending over

the following three and five years is inconsistent with the investor conflict of interest hypothesis.

Overall, the evidence supports underwriters’ venture investments in IPO issuers serving as a

credible certification mechanism and a means to better align underwriter interests with issuers, rather than

creating a serious conflict of interest problem for IPO investors. The lack of evidence of a moral hazard

problem could reflect the limited benefits that underwriters realize under these circumstances from

allocating underpriced IPOs, combined with underwriter commitments to retain their pre-IPO shares for

six months beyond the IPO under a typical lock-up clause. In European and Asian nations, where lock-up

clauses are generally not used, existing empirical evidence indicates that the conflict of interest effect is

much stronger, often dominating the certification effect.

30

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34

Appendix Definitions of variables used in the analysis

Underpricing (%) (Closing Price on Trading Day 0 / Offer Price) – 1

Price Revision (%) (Offer Price - Midpoint of Initial Filing Range) / Midpoint of Initial Filing Range

Gross Spread (%) Direct underwriter compensation / Offer Size

Delisting 3- and 5-Year Rate Indicator Equals 1 if the IPO Issuer is Delisted for not Meeting Exchange Requirements Within 3 and 5 Years of the IPO Date, respectively, and 0 Otherwise.

Market-to-Book Ratio after 3/5 years Ratio of Issuer Market Value of Assets to its Book Value 3 and 5 Years after IPO

Underwriter Shares (%) Pre-IPO Issuer Shares Held by all Underwriter Syndicate Members

Lead Shares (%) Pre-IPO Issuer Shares Held by Lead Underwriters

Nonlead Shares (%) Pre-IPO Issuer Shares Held by Nonlead Underwriters

Underwriter Share (HV/LV) (%) Interaction of Underwriter Stockholdings and an Indicator Variable Equaling 1 if IPO Stock Return Standard Deviation over Event Days +21 to +270 Is (above/below) the Median of the Sample IPOs and 0 otherwise

Warrant Ownership (%) Lead Underwriter Warrant Ownership / Post-IPO Issuer Shares Outstanding (%)

Stock Return Standard Deviation (%) IPO Stock Return’s Standard Deviation Over Event Days +21 to +270

Manager Ownership (%) Percentage of Pre-IPO Share Held by All Non-Director Executives including CEO

VC Ownership (%) Percentage of Pre-IPO Share Held by Traditional and Corporate Venture Funds

Tangible Assets (%) Issuer Plant, Property, Equipment / Total Assets, at the Fiscal Year-end Prior to IPO

Total Assets Issuer Total Assets in the Fiscal Year-end Prior to IPO ($Millions)

Offer Size ($Millions) Offer Price x Shares Offered (Prior to Exercise of Overallotment Options)

Shares Offered (%) Total Number of IPO Shares Offered / Post-IPO Shares Outstanding

Secondary Shares Offered (%) Number of Secondary Shares Offered / Total Number of IPO Shares Offered

Prior Market Return (%) Average Nasdaq or NYSE Market Return over Event Days -270 to -21

Recent IPO Activity Total Number of IPOs over the Prior 3 Months

Filing Date to IPO Interval Trading Days Between an IPO’s Initial Filing Date and Actual Issuance Date

Bubble Period Indicator Equals 1 if IPO Is Completed in 1999 or 2000, and 0 Otherwise

Underwriter Reputation Investment Bank Rankings of Lead Underwriters from Ritter and Loughran (2004)

Section 20 Subsidiary Indicator Equals 1 if Lead Underwriters are Section 20 Subsidiaries

Leads and Co-Managers Number of Leads, Co-Leads and Co-managers in IPO

VC Age Age of VC at IPO

Firm Age Age of Issuer at IPO from Ritter and Loughran (2004)

Global Offering Indicator Equals 1 if IPO Is a Simultaneous Global Offering, and 0 Otherwise

Internet Indicator Equals 1 for Internet Issuers Defined in Ritter and Loughran (2004)

Technology Indicator Equals 1 for Technology Issuers Defined in Ritter and Loughran (2004)

QIU Indicator Equals 1 When a QIU is Used in an IPO

35

Table 1

Predictions of our hypotheses for underwriter shareholdings Three hypotheses concerning underwriter share ownership in IPO issuers are examined: IPO investor conflict of interest, underwriter-shareholder certification, and alignment of interest. A “+” indicates a prediction of greater underpricing and a “-”of less underpricing; “0” stands for a predication with no relation between underwriter shareholdings and the dependent variable. N/A is used for cases in which a hypothesis has no predictions for the relation between underwriter shareholdings and the dependent variable. Dependent Variables Investor Conflict of Interest Certification Issuer Alignment of Interest Underpricing + - - Abs (Price Revision) + - N/A Price Revision + N/A + Gross Underwriting Spread N/A - - Delisting Frequency + - / 0 N/A Market-to-Book Ratio - + / 0 N/A

36

Table 2 Summary statistics on prior underwriter share ownership

Descriptive statistics are for our sample of venture-backed IPOs completed between January 1993 and December 2000 by U.S. issuers. Underwriters are distinguished by whether or not they hold shares in the issuer at the time of the IPO. Variable definitions are given in the Appendix.

Panel A. Summary Statistics of Overall IPO Sample

All 1993 1994 1995 1996 1997 1998 1999 2000

Number of Venture-Backed IPOs 1480 211 131 183 256 127 76 268 228

Percent of IPOs with Underwriter- Shareholders 32.7 33.6 18.3 27.9 28.9 29.1 35.5 39.6 41.2

Percent of IPO Sample 100 14.3

8.8

12.5 17.3

8.6

5.1 18.1

15.4

Panel B. Summary Statistics of IPOs with Underwriter Ownership

All 1993 1994 1995 1996 1997 1998 1999 2000

Shareholdings of All Underwriters (No.) 484 71 24 51 74 37 27 106 94

(%) 11.0 18.6 13.0 12.7 11.2 8.7 10.4 7.0 9.1

Shareholdings of Lead Underwriters (No.) 298 42 18 32 51 22 17 63 53

(%) 10.4 15.4 12.6 12.3 11.3 4.5 10.4 6.5 10.6

Shareholdings of Nonlead Underwriters (No.) 265 38 8 25 31 21 17 65 60

(%) 8.4 17.8 10.8 10.3 8.1 10.5 6.0 5.2 4.9

Warrant Holdings of Lead Underwriters (No.) 102 27 19 13 16 11 6 4 6

(%) 5.0 4.7 5.7 4.4 5.5 7.6 4.7 1.4 1.7

37

Table 3 Mean statistics for issue characteristics by pre-IPO underwriter shareholdings

Descriptive statistics are for our sample of venture-backed IPOs completed between January 1993 and December 2000 by U.S. issuers. The sample is also divided by whether one or more underwriters are a pre-IPO shareholder in the issuer. Variable definitions are given in the Appendix.

Overall Sample Underwriter

No Shares Shares

Underpricing (%) 39.4 38.1 42.0

Offer Price ($) 13.1 12.8 13.8

Price Revision (%) 7.3 6.2 9.6

Abs Price Revision (%) 19.9 19.3 21.1

Gross Spread (%) 7.0 7.1 7.0

Delisting 3-Year Rate (%) 8.4 7.4 10.3

Delisting 5-Year Rate (%) 12.8 13.0 12.3

Market-to-Book Ratio after 3 Years 1.11 1.15 1.02

Market-to-Book Ratio after 5 Years 0.92 0.86 1.09

Total Assets ($Millions) 90.8 47.8 179.3

Tangible Assets (%) 24.6 25.3 23.2

Firm Age 8.7 8.8 8.5

Manager Ownership (%) 16.5 17.0 15.6

VC Ownership (%) 53.9 57.6 46.2

Offer Size ($Million) 57.8 50.4 73.2

Shares Offered (%) 42.7 44.4 39.3

Secondary Shares Offered (%) 8.2 8.8 7.0

Global Offering (%) 25.9 21.7 34.7

VC Age 14.8 15.1 14.2

Underwriter Reputation 7.8 7.7 8.1

Section 20 Subsidiary (%) 20.3 18.0 25.0

Leads and Co-Managers 2.8 2.6 3.0

QIU Used (%) 10.9 1.5 30.2

Bubble Period (%) 33.5 29.7 41.3

Filing Date to IPO Interval 57.6 58.0 56.8

Recent IPO Activity 145.4 146.7 142.5

Prior Market Return (%) 6.9 6.9 7.1

Internet (%) 22.0 18.4 29.3

Technology (%) 31.0 30.8 31.4

38

Table 4 Effect of prior underwriter shareholdings in an issuer on IPO underpricing

Table 4 presents estimates of the relation between IPO underpricing and underwriter shareholdings. Our sample is based on venture-backed IPOs completed between January 1993 and December 2000 by U.S. issuers. Columns (1)-(4) present results for the model: 0 1 2Underpricing a a UPCT a Control Variables ε= + ⋅ + ⋅ + . The dependent variable Underpricing represents the IPO first-day percentage return. UPCT represents pre-IPO percentage shareholdings of classes of underwriters. Variable definitions are given in the Appendix. Columns (1)-(2) present results for the full sample and columns (3)-(4) presents results for the 1993-1998 pre-bubble and 1999-2000 bubble periods, respectively. Column (5) presents results for the model: 0 1 2Underpricing a a UPCT a UPCT Information Asymmetry= + ⋅ + ⋅ ⋅

3a Control Variables ε+ ⋅ + . Information asymmetry is measured by two indicator variables based on stock return variance estimates over event days +21 through +270 following the IPO. HV represents high variance returns above the sample median and LV represents low variance returns below the sample median. The models are estimated with ordinary least squares and heteroscedasticity-consistent t-statistics are reported.

Overall Sample Subsample Periods Information Asymmetry

1993-1998 1999-2000

1 2 3 4 5

Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat

Underwriter Shares -0.71 -6.37 Lead Shares -0.74 -5.81 -0.17 -3.00 -0.98 -3.59

Nonlead Shares -0.63 -3.75 -0.13 -2.11 -2.55 -4.53

Lead Shares (HV) -1.00 -5.16

Lead Shares (LV) -0.46 -3.57

Nonlead Shares (HV) -1.73 -4.43

Nonlead Shares (LV) -0.31 -2.33

Warrant Ownership 1.96 3.49 1.97 3.52 0.80 2.73 -0.49 -0.08 1.96 3.52

Manager Ownership -0.03 -0.38 -0.03 -0.38 0.15 2.43 -0.23 -0.81 -0.03 -0.39

VC Ownership -0.19 -2.84 -0.19 -2.80 0.02 0.37 -0.49 -2.81 -0.18 -2.65

Tangible Assets -0.04 -3.18 -0.04 -3.20 -0.01 -4.61 -0.33 -3.54 -0.04 -3.48

Log (Total Assets) -7.59 -6.32 -7.61 -6.33 -4.94 -7.41 -14.32 -3.54 -8.10 -6.68

Log (Offer Size) 25.46 7.56 25.50 7.57 9.47 6.03 52.42 5.69 25.54 7.56

Shares Offered -0.21 -3.98 -0.21 -3.98 -0.08 -4.18 -1.37 -4.32 -0.22 -3.98

Prior Market Return 1.09 6.17 1.09 6.16 0.27 2.56 1.55 6.62 1.10 6.16

Underwriter Reputation 0.25 0.25 0.23 0.23 2.11 3.90 -2.73 -0.57 0.32 0.32

Global Offering 25.24 5.25 25.24 5.25 5.68 1.55 26.40 3.31 26.71 5.51

Internet 32.44 5.69 32.47 5.70 20.46 3.01 14.81 1.75 33.81 5.89

Filing Date to IPO Interval -0.05 -2.49 -0.05 -2.51 -0.02 -1.29 -0.07 -1.06 -0.04 -2.04

Intercept -29.38 -3.75 -29.46 -3.76 -16.73 -3.73 -26.59 -0.59 -29.70 -3.85

Adjusted R2 0.33 0.33 0.18 0.28 0.33

Number of Observations 1480 1480 984 496 1480

39

Table 5 Effect of prior underwriter shareholdings after controlling for selection bias

Table 5 presents estimates of the relation between IPO underpricing and underwriter shareholdings, after controlling for selection bias. Our sample is based on venture-backed IPOs completed between January 1993 and December 2000 by U.S. issuers. Estimates are based on the following two-step estimation procedure:

First Step: 0 1( )Tobit UPCT a a Control Variables ε= + ⋅ + , Second Step: 0 1 2 3Underpricing a a UPCT a Control Variables a Lambda ε= + ⋅ + ⋅ + + .

In the first-step Tobit regression, the dependent variable, UPCT, represents classes of underwriters’ prior shareholdings in an issuer. Variable definitions are in the Appendix. The second-step estimation uses ordinary least squares (OLS), where the dependent variable, Underpricing, is the IPO first-day percentage return. Lambda is the inverse Mills ratio. Heteroscedasticity-consistent t-statistics are reported in the second-step OLS estimation.

First-Step Tobit Estimates Second-Step OLS Estimates

1 2 3 4

Lead Nonlead Lead Nonlead

Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat

Underwriter Shares -0.84 -5.12 -0.44 -2.66

Internet 2.23 0.77 18.42 7.38 30.97 5.21 31.03 5.34

Technology -9.32 -2.73 1.99 1.51

Section 20 Subsidiary 8.58 3.02 2.60 2.54

Firm Age -5.38 -3.36 -1.51 -1.67

VC Age -0.21 -1.55 0.09 1.56

Warrant Ownership 1.70 2.70 1.48 2.37

Manager Ownership -0.01 -0.14 0.02 0.24

VC Ownership -0.16 -2.25 -0.14 -2.00

Tangible Assets -0.04 -3.19 -0.05 -2.73

Log (Total Assets) -8.21 -6.37 -8.68 -6.45

Log (Offer Size) 26.25 7.36 25.62 7.34

Shares Offered -0.23 -3.63 -0.23 -3.60

Prior Market Return 1.14 6.30 1.15 6.29

Underwriter Reputation -0.19 -0.18 0.26 0.24

Global Offering 27.02 5.42 26.34 5.31

Filing Date to IPO Interval -0.05 -2.48 -0.05 -2.39

Lambda 0.15 0.90 -0.10 -0.37

Intercept -11.26 -3.13 -24.82 -9.11 -29.73 -3.53 -30.79 -3.67

Pseudo / Adjusted R2 0.08 0.09 0.32 0.32

Number of Observations 1480 1480 1480 1480

40

Table 6 Effect of prior underwriter shareholdings on IPO price revisions

Table 6 presents ordinary least squares estimates of the effect of underwriters’ prior percentage shareholdings on percentage IPO price revisions and their absolute values for a sample of venture-backed IPOs completed between January 1993 and December 2000 by U.S. issuers. The dependent variable in column (1), Abs (Price Revision), is the absolute value of the Price Revision. The dependent variable in column (2) is Price Revision defined as the difference between IPO offer price and the midpoint of the filing range divided by the same filing range midpoint in percentage. Variable definitions are given in the Appendix. The t-statistics are based on heteroscedasticity-consistent standard errors.

Absolute Price Revisions Price Revisions

1 2

Coeff. t-stat Coeff. t-stat

Lead Shares -0.18 -4.55 -0.22 -4.37

Nonlead Shares -0.12 -1.86 -0.15 -1.79

Warrant Ownership 0.08 0.26 1.55 4.24

Manager Ownership 0.00 0.16 0.04 1.21

VC Ownership -0.03 -1.14 -0.06 -2.60

Tangible Assets -0.01 -4.28 -0.03 -3.39

Log(Total Assets) -2.10 -4.19 -4.80 -7.98

Log(Offer Size) 5.82 4.56 21.08 14.93

Shares Offered -0.06 -2.93 -0.06 -4.39

Prior Market Return 0.26 4.01 0.70 10.42

Global Offering 3.57 2.21 3.82 2.16

Recent IPO Activity 0.02 1.84 -0.03 -1.81

Bubble Period 4.63 2.96 -8.26 -4.58

Internet 6.69 3.42 9.54 4.52

Technology 1.19 0.85 5.50 3.60

Filing Date to IPO Interval -0.01 -1.12 -0.03 -2.89

Intercept 0.39 0.09 -51.57 -10.34

Adjusted R2 0.18 0.40

Number of Observations 1480 1480

41

Table 7 Effect of prior underwriter share ownership on IPO gross spreads and its components

Table 7 presents estimates of the relation between underwriter shareholdings and IPO gross spread (or its components) for venture-backed IPOs completed between January 1993 and December 2000 by U.S. issuers. A logistic regression model of the following model is estimated: 0 1 2Gross Spreads and its Components a a UPCT a Control Variables ε= + ⋅ + ⋅ + . where all the dependent variables are defined as percentages of gross proceeds, e.g., the dependent variable in column (1) is the logarithm (gross spread / (100 – gross spread). Column (1) reports the results for gross spread, column (2) for management fee, column (3) for underwriting fee, and column (4) for selling concessions. UPCT represents classes of underwriters’ pre-IPO percentage shareholdings in the issuer. Variable definitions are given in the Appendix. Coefficient estimates are reported in percentages.

Gross Spread Management Fee Underwriting Fee Selling Concession

1 2 3 4

Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat

Lead Shares -0.05 -2.06 -0.05 -2.22 -0.04 -1.58 -0.06 -1.53

Nonlead Shares -0.01 -0.56 -0.04 -1.67 0.00 -0.07 0.00 -0.15

Warrant Ownership 1.17 4.10 2.08 3.05 -0.54 -1.13 0.99 4.31

Tangible Assets 0.00 -4.83 0.00 -4.06 0.00 -2.72 0.00 -2.59

Log (Total Assets) -0.45 -2.44 -0.69 -2.44 -0.50 -1.63 -0.24 -0.97

Log (Offer Size) -3.24 -8.24 -2.39 -4.29 -8.72 -13.62 -0.89 -1.71

Prior Market Return 0.02 1.97 0.00 0.21 -0.05 -1.98 0.05 2.42

Underwriter Reputation -0.85 -3.45 -1.29 -3.24 -0.48 -1.26 -0.53 -2.01

Global Offering 1.17 3.49 0.67 1.15 1.90 2.67 0.86 1.58

Recent IPO Activity -0.01 -1.69 0.00 -0.57 0.00 -0.14 -0.01 -1.67

Bubble Period 2.27 5.77 1.33 1.92 -1.51 -2.04 3.49 4.90

Firm Age -0.55 -3.06 -0.87 -2.88 0.78 2.17 -0.74 -3.26

Intercept -237.74 -99.31 -401.13 -106.20 -380.50 -108.39 -307.51 -108.87

Adjusted R2 0.48 0.29 0.34 0.14

Number of Observations 1480 1480 1480 1480

42

Table 8 Effect of prior underwriter shareholdings on long-run performance

Table 8 presents evidence on the relationship between measures of long-run performance for venture-backed IPOs and underwriter shareholdings completed between January 1993 and December 2000 by U.S. issuers. Columns (1) and (2) present estimates for the following probit model:

0 1 2( 1, 0)Delisting Yes No a a UPCT a Control Variables ε= = = + ⋅ + ⋅ + , where the dependent variable is an indicator variable taking a value of one if the stock is delisted for financial reasons within three and five years of its IPO offer date, respectively, and is zero otherwise. UPCT represents underwriters’ pre-IPO percentage shareholdings in the issuer. There are 124 delisting within three years from a sample of 1,480 IPOs and 126 delistings over five years from a sample of 949 IPOs. Columns (3) and (4) present ordinary least square regressions of underwriter shareholdings with the dependent variable, post-IPO Tobin’s Q. T-statistics are based on heteroscedasticity-consistent standard errors. Tobin’s Q is measured by the issuer’s ratio of market value to book value of assets at three and five years after the IPO, respectively. Market value is measured by book assets plus market value of common stock less the book value of common stock and deferred taxes. The market values and book values are measured at the end of the calendar year and fiscal year, respectively. The market-to-book ratio of the individual IPO issuers is adjusted for the industry’s median market-to-book ratio using Fama and French (1997) industries. Variable definitions are given in the Appendix.

Delisting Within Tobin’s Q Post-IPO

Three Years Five Years Three Years Five Years

1 2 3 4

Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat Lead Shares -0.01 -0.24 -0.01 -0.56 -0.01 -1.44 0.01 0.49

Nonlead Shares -0.02 -1.24 -0.01 -0.19 0.02 1.37 0.01 1.04

Warrant Ownership 0.07 1.90 -0.04 -0.89 0.01 0.18 0.16 1.41

Log (Total Assets) 0.19 3.67 0.11 1.90 -0.37 -2.59 -0.42 -2.38

Log (Offer Size) -0.07 -0.36 0.66 1.96

Shares Offered 0.01 2.65 0.01 2.67 -0.02 -4.95 -0.01 -2.72

Secondary Shares Offered -0.01 -0.49 -0.02 -3.76 -0.01 -1.72 0.01 -0.73

Underwriter Reputation -0.10 -2.06 -0.12 -2.60

Leads and Co-Managers 0.04 0.65 0.24 2.72 -0.01 -0.04 -0.52 -2.25

Recent IPO Activity 0.01 2.60 0.01 2.58 0.01 2.54 0.01 -0.90

Internet 0.40 2.70 -0.15 -0.52

Stock Return Standard Deviation 0.22 7.90 0.24 5.88 -0.20 -2.38 0.04 0.39

VC Age 0.01 0.62 0.01 1.17

Firm Age -0.08 -1.09 -0.08 -1.07 -0.52 -2.08 -0.20 -1.35

Gross Spread 0.05 0.37 0.36 2.56

Underpricing -0.01 -2.12 -0.01 -0.28

Intercept -3.92 -3.19 -5.50 -4.31 4.51 3.70 2.24 1.83

Pseudo R2 / Adjusted R2 0.29 0.28 0.06 0.06

Number of Observations 1480 984 885 445