The role of venture capital backing in initial public offerings has been the subject of considerable debate in the finance literature. Two seminal papers in this literature are Megginson and Weiss (1991) and Barry, Muscarella, Peavy, and Vetsuypens (1990). Megginson and Weiss (1991) document that venture capital (VC) backed IPOs were less underpriced than non-VC backed IPOs during 1983-1987, attributing this difference to venture capital “certification.” Venture capital certification (the “certification hypothesis” from now on) reflects the notion that venture capitalists, being repeat players in the IPO market, are concerned about their reputation in that market, so that they price the equity of the IPOs of firms backed by them closer to intrinsic value (and credibly convey this fact to the IPO market). Similarly, Barry et al (1990) document that VC backed IPOs were less underpriced than non-VC backed IPOs between 1978 and 1987. They, however, attribute this difference in underpricing to the capital market’s recognition of “IPOs with better monitors.” In broader terms, the idea here is that since venture capitalists fund only a small minority of firms, these firms are of better quality than non-VC backed firms (“screening”). Further, since venture capitalists devote considerable time to monitoring firm management (in the pre-IPO stage), the quality of firms brought public with VC backing is likely to be higher than that of non-VC backed firms, even if their quality at the time the VC got involved with them was similar to that of non-VC backed firms (“monitoring”). Since both screening and monitoring by VCs will lead to similar results, namely, higher firm quality for VC backed firms compared to non-VC backed firms at the time of IPO, we will refer to this role of venture backing as the “screening and monitoring hypothesis” or simply “screening” from now on.
More recent papers have, however, called the above early evidence into question. Lee and Wahal (2002) document that, between 1980 and 2000, IPOs of VC backed firms were, in fact, more underpriced than those of non-VC backed firms. A number of other papers have also presented similar results: see, e.g., Loughran and Ritter (2003). This, in turn, has reopened the debate about the role of venture backing in IPOs. The main objective of this paper is to attempt a resolution of the above debate by approaching it from a new perspective and using a new methodology. We propose to distinguish between the two roles of venture backing in IPOs discussed above, and a third possible role that we refer to as “market power”. The market power hypothesis captures the notion that venture capitalists are able to develop long-term relationships with various participants in the IPO market (underwriters, institutional investors, and analysts) due to their role as powerful repeated players in that market. These relationships enable them to attract greater participation by these market players in the IPOs of firms backed by them, thus obtaining a higher price for the equity of these firms (both in the IPO and in the secondary market). The market power and certification hypotheses have dramatically different implications for the pricing of IPOs: while the certification hypothesis implies that venture capitalists price IPOs of firms backed by them closer to intrinsic value due to their concern for preserving reputation in the IPO market, the market power hypothesis implies that venture capitalists’ objective is to obtain the highest price possible for these IPOs (by taking advantage of their relationships with various market participants).
Our view is that, while the difference in underpricing between VC backed and non-VC backed IPOs is interesting to study in itself, it may not be the most appropriate measure to analyze if our objective is to distinguish between the various potential roles of VC backing in IPOs. This is because “underpricing” (or the initial returns to an IPO) simply reflects the price rise of a firm’s equity from the IPO offer price to the first day closing price in the secondary market, so that it is affected not only by the pricing of this equity in the IPO, but also by the pricing of this equity at the close of the first trading day in the secondary market. This implies that, for underpricing to be a meaningful measure in any study of the economic role of venture backing, one has to make the crucial (and rather strong) assumption that the closing price of a firm’s stock on the first day of secondary market trading is not affected by venture backing and always equals the intrinsic value of that stock. Thus, if venture backing affects not only the IPO price of a firm but also the first day secondary market close then underpricing is no longer useful in determining the economic role of venture backing in IPOs. We will discuss in more detail why underpricing is not the most appropriate measure to assess the economic role of venture backing in IPOs in Section 2.
We therefore study four sets of direct measures in our analysis of the role of venture backing in IPOs, which we feel yield more insight into the economic role of venture backing. The first measure we study is the ratio of the valuation placed on the firm in the IPO (valuation at the offer price, OP), to its intrinsic value (IV). Clearly, if the role of venture backing in IPOs is that of certification, one would expect venture backed firms to be priced closer to intrinsic value than non-venture backed companies, so that this ratio would be closer to one for venture backed firms. Similarly, one would expect equity in the IPOs of firms backed by high-reputation VCs to be priced closer to intrinsic value than equity in the IPOs of firms backed by low-reputation venture capitalists. In contrast, the market power hypothesis, which implies that the role of VCs is simply to obtain a higher valuation for firms in IPOs by attracting higher quality underwriters, more institutional investors, and more analyst coverage, would imply that the ratio of IPO firm value to intrinsic value would be larger for VC backed IPOs than for non-VC backed companies, and larger for the IPOs of firms backed by high-reputation VCs relative to those backed by low-reputation VCs.
The second measure we study is the ratio of the secondary market valuation placed on a firm at the close of the first trading day in the secondary market (SMP) to its intrinsic value (IV). Given that firm value is now determined by the equity market (once the firm’s shares start trading in the secondary market), the certification hypothesis does not have any predictions for this ratio: under this hypothesis, this ratio should be the same across VC backed and non-VC backed IPOs (and across the IPOs of high-reputation VC backed and low-reputation VC backed firms). In contrast, the market power hypothesis predicts that this ratio will be higher for the IPOs of VC backed firms than for non-VC backed firms, since one would expect the valuation impact of participation by higher reputation underwriters, more analyst coverage, and more institutional investors attracted by venture capitalists to persist for some time after the IPO. Of course, as time goes by, one would expect this valuation difference between VC backed and non-VC backed IPOs to go down (under the market power hypothesis), as the effect of venture backing dissipates over time. We therefore study the ratio of secondary market valuation to intrinsic value at the end of one year, two years, and three years after the IPO.
