Since the 1970s, the underpricing of IPOs has been a well-observed phenomenon and many issuers see their stock price rising sharply on the first day of trading, which means that the IPO firm could have realized higher proceeds from the offering (“money left on the table”). As a result, venture capitalists and Silicon Valley companies recently expressed their dissatisfaction with traditional IPOs, blaming underwriters for intentionally underpricing shares in new issues. However, in recent years, global IPO activity has only increased and it quickly recovered from the initial impact of the COVID-19 pandemic. As a traditional IPO is still the most common way for firms to go public, there is a need for further research on how firms can ensure a successful IPO and effectively reduce the level of underpricing.
Traditionally, information asymmetries serve as a dominant explanation for the underpricing phenomenon, as potential investors have only limited information about the issuer and judge IPOs based on a subjective probability of future success. In this sense, higher ex-ante uncertainty about the value of the issuer results in a higher level of underpricing. However, the relationship between the issuer and the underwriters also creates agency costs through information asymmetries, as underwriters have informational advantages about the structure of the capital market and the demand for the issuer’s shares. IPO firms thus need to overcome these information asymmetries and convey their (expected) value to underwriters and potential investors.
In this regard, one important aspect during an IPO is the quality of the issuer’s corporate governance. During an IPO process, IPO firms shift from private to public status and transform their organization to conform with the scrutiny of the regulator and the investor community. While inside directors, who are part of the management team, are mainly responsible for leading the firm through the process of going public, outside directors are a viable resource for knowledge and provide advice to the issuer as internal resources of the issuer are limited. Thus, both inside and outside directors are actively involved in the IPO process and can affect the IPO’s outcome. Therefore, it is not surprising that research shows that governance characteristics, such as board independence and size, are relevant determinants of the level of underpricing and the probability of an IPO’s withdrawal.
A relevant aspect of board composition is financial expertise. From a governance perspective, financial expertise equips directors, particularly outside directors, with relevant knowledge to fulfill their monitoring duty, e.g., in the context of the financial reporting process. In this sense, studies find that board monitoring activity is positively associated with firm value, while weak governance structures increase the likelihood of failure and involuntary delisting of newly listed firms. Consequently, a presence of directors with financial expertise is potentially a positive signal that reduces investor uncertainty about the value of the issuer.
Additionally, financial expertise enables directors to evaluate financial information and challenge assumptionspresented by external advisors or underwriters. Furthermore, financial expertise can positively affect the issuer’s financial reporting and thus convey the value of the issuer to potential investors more credibly. Thus, directors with financial expertise potentially strengthen the issuer’s position in relation to the underwriter when it comes to negotiations about the appropriate valuation of the issuer and equally enhance the way the issuer is presented to potential investors, e.g., during roadshows. Consequently, directors with financial expertise should also reduce information asymmetries through direct interaction with investors and the underwriters, leading to less uncertainty about the value of the issuer. To test this discussion empirically, I conduct a comprehensive analysis of how board’s financial expertise affects the IPO process.
Methodology and Data
From the Thomson Reuters SDC database, I collected a sample of 617 IPOs that were issued at the NYSE or Nasdaq between January 2014 and December 2017. In line with the empirical IPO literature, I exclude real estate investment trusts (REITs), Unit Offerings, American Depositary Shares (ADS), offerings with an offer price below $5, and financial firms (with SIC codes between 6000 and 6999) from the sample and end up with a final sample size of 414 completed IPOs. I manually collect the characteristics of the board of directors from the S-1 filings and complement the data with information from Bloomberg and LinkedIn. Company and issue-related data is obtained from Thomson Reuters and verified with the data from the S-1 filings, which are retrieved from EDGAR. I conduct the same procedure for withdrawn IPOs in the period 2014–2017 and collect data on 85 withdrawn IPOs. Following prior literature on IPOs, underpricing is computed as the difference between the closing price on the first trading day and the offer price. To capture the board’s financial expertise, I apply the SEC rules for financial experts and use the percentage of directors with financial expertise on the board as an independent variable.
Findings and Contribution
My results show that the ratio of financial experts on the board is negatively associated with IPO underpricing. However, I also document that my results are driven by financial experts among outside directors. Thus, this underlines the importance of knowledge provided by outside directors and their positive signaling effect for issuing firms. Exploratory results of quantile regressions show that the effect of financial expertise is strongest for issues with higher levels of ex-ante uncertainty. The analysis of IPO withdrawals reveals that outside director financial expertise is also associated with a reduced probability of IPO withdrawal.
Consequently, by highlighting that board’s financial expertise is crucial for the entire IPO process, my study contributes to the IPO and corporate governance literature. As this study considers both completed and withdrawn IPOs, it provides a comprehensive analysis of the association between director’s financial expertise and the IPOs’ outcomes. Above that, my study contributes to the IPO literature from a methodological perspective as it is among the first to employ quantile regressions in the IPO context. I demonstrate that directors with financial expertise are the most valuable for issuances that have higher levels of uncertainty surrounding the offering. From a practical point of view, firms preparing for an IPO should implicitly consider financial expertise when (re)appointing directors to the board.
While my study offers important contributions, it also has its limitations. The number of IPOs and the level of underpricing are subject to specific market conditions which change over time. Although the years 2014–2017 can be considered as moderate IPO years that capture the average IPO market of the last two decades, my sample covers only four years and shows neither typical characteristics of cold nor hot market conditions. Also, the natural focus of this paper is on companies that go public, which are smaller and more dynamic than the average listed company and a large portion of the sample belongs to either the biotech or software industry. Thus, one should be careful not to generalize these findings for other firms or IPO market conditions. Although quantitative research can prove the beneficial effect of director financial expertise in the IPO context, it does not directly unveil through which channels directors affect IPOs’ outcomes. As the IPO process is complex and highly dynamic, future research could take a more in-depth view of the role of the board of directors during an IPO on a qualitative level.
Marvin Nipper is a Ph.D. student at the University of Duisburg-Essen.
This post is adapted from his paper, “Board financial expertise and IPO performance – an analysis of U.S. public offerings and withdrawals”, published in Corporate Ownership & Control, 18(3), 307–324 and available on SSRN.