Valuation in initial public offerings (IPO) of firms has always received much academic attention. Scholars generally employ theories such as signaling theory under the asymmetric information to explain it. Grossman and Stiglitz () suggest that the inadequate or unauthentic disclosure of information in an imperfect market and the different capabilities to acquire, perceive, and understand information of market participants will affect their decision making and the risk premium by holding different quantity and quality of information. Only information of price is offered in the stock market, and other information about a listed firm is highly asymmetric. Information asymmetry exists between regulatory authorities and listed companies, between listed companies and investors, as well as between institutional investors and individual investors. Greenwald and Stiglitz () point out that information is the foundation of financial market operations, and hence, such information asymmetry would cause many problems for the market. For instance, due to prior information asymmetry, products with bad quality will drive out those with good quality because of adverse selection, which will eventually result in the whole quality decline of the products traded in the market.
Allen and Faulhaber () show that it is difficult for investors to effectively differentiate good from bad, when the performances of firms vary in the market. But the firms with good performances certainly wish to distinguish themselves from those with bad performances, and they generally can signal to the investors by making use of the IPO pricing. Although having a lower initial issue price, a firm can make up for its losses in IPO during the second public offerings with a higher issue price, a higher potential growth, and promising future prospects to investors. On the other hand, firms with bad performances are unwilling to do so because they do not have beautiful futures and the losses from low IPO prices may not be compensated by the next public offering of shares.
From the view of signal theory, investors can improve their weak position in information asymmetry by acquiring signals. Deeds et al. () say that ‘certain variables or indicators send signals to potential investors about the capabilities and thus future value of firms’. Some scholars (Daily et al. ) believe that insiders are more informed about the IPO firm's potential than outsiders. Specifically, the managers with high-quality information of firms will signal to potential investors through their capital structures or dividend policies (Ross ). With a lack of clear signals to evaluate the existing values or when such signals are unobservable, the organizational and governance symbol can be used as an effective way to reduce uncertainty in IPO.
Many researchers made a lot of empirical tests on signal in IPO valuation from different angles, but something is still in an equivocal way. Specially, there is still little study for entrepreneurial firms in China. As the characteristics, the insiders occupied a dominant position of the entrepreneurial firm's ownership in China, while there are nominated independent directors as decorations forced by regulation when the entrepreneurial firms go to IPO. Therefore, we tend to study the impact of insiders and outsiders on IPO valuation for entrepreneurial firms listed in China's Growth Enterprise Market and try to find something specially.
Literature review and hypotheses
In considering corporate governance, we generally focus on inside directors and outside directors, and board compositions are thought as the proportion of outside and inside directors on the board. Specially, the existence of an outside director is regarded as a signal of the director's independency. Some researches argue that outside directors are effective in resolving agency problems (Johnson et al. ) because outsiders have incentive to signal their managerial competence to employers and their expertise in monitoring management. However, empirical evidence on the relationship between outside directors and firm performance is in an equivocal way. Schellenger et al. () find that bigger percentages of outside directors are associated with increased financial performance, while others suggest that outside directors are ineffective in monitoring management. Arthurs et al. () believe that internal supervision and experiences from the board of directors reduce IPO underpricing due to a higher valuation in IPO.
Baysinger and Butler () show, based on a sample of 266 firms between 1970 and 1980, that the firms with a higher proportion of independent directors have a better performance. Chahine and Filatotchev () suggest that, according to agency theory, independent directors increase monitoring of the firm management and add to firm value with strategic advices and external knowledge and resources. With high costs of takeover, non-managing shareholders prefer strict monitoring of the management team by independent directors. The existence of independent directors also represents sound governance structure and offers outside investors with additional information that ensures better IPO performances. A more important finding of Leone et al. () is that if the incumbent independent directors restrict the opportunism of the management and reduce the potential strategic mistakes, they also are able to limit unnecessary information disclosure, because excessive and unnecessary information disclosure will reduce competitiveness of the firm. Therefore, independent directors will raise IPO valuation. We offer the following hypothesis:
Hypothesis 1: The IPO valuation of entrepreneurial firms by means of the issue premium in IPO will be positively associated with the board independency measured by the percentage of independent director number; the higher the board independency measured by the percentage of independent director number is, the higher the valuation of an entrepreneurial firm by means of the issue premium in IPO is.
Kroll et al. () suggest that the initial top management team (TMT) members have accompanied the firms for many years and possess tacit knowledge and common visions. The establishment of such common visions requires long time of fostering and continuous interaction. TMTs with common goals usually are more flexible, respond more quickly to changes, and handle problems better. They also believes that the initial TMTs are the primal providers of key human resources for IPO firms, and such human resources exist in the tacit knowledge and personal investment of TMT members in the growth processes of firms. The acquisition of tacit knowledge is also relatively difficult because it is established on the mutually trusting interpersonal relationship, while common visions are formed gradually in long-term work. The ownership status of TMT is observable by outside investors because firms are obliged to disclose the ownership status and compensatory arrangements of their TMTs. Beatty and Zajac () point out that ownership arrangement enables the management team to diversify the risk of firm failure. Investors may regard such risk diversification as signals of management devotion and corporate quality and performance.
Jain and Kini () believe that the performances of IPO firms are often unsatisfactory due to the agency problem. This echoes the opinion of Jensen and Meckling () that managers of IPO firms may misuse their new positions as agents because they reap enormous monetary and non-monetary benefits by selling the shares they hold and having no exit costs to face. Therefore, if the TMT holds a larger proportion of the firm's shares, the agency problem will be less severe. Researches also show that the higher the proportion of firm shares held by its TMT, the more capable to signal to outside investors positively (Barney et al. ; Filatotchev and Bishop ; Florin et al. ).
Florin and Simsek () suggest that managerial personnel are more inclined to underpricing when they can reap more benefits from IPO than their original benefits. Zimmerman () thinks that TMT heterogeneity provides a signal to potential investors about the quality of IPO which is associated with greater capital accumulations in the future. Other researches find that the higher the proportion of firm shares held by its TMT, the more possibility to affect the issue price of IPO positively (Carter and Auken ; Certo ).
The top management team, as the insiders of a firm, holds more information on the real value of an IPO firm than the outside investors. According to signaling theory, the shareholding of TMT delivers a message about the firm value. If TMT members sell stocks they hold largely, it means that the firm is overvalued. Hence, we offer the following hypothesis:
Hypothesis 2: The IPO valuation of entrepreneurial firms by means of the issue premium in IPO will be positively associated with the TMT ownership; the higher the TMT ownership is, the higher the valuation of an entrepreneurial firm by means of the issue premium in IPO is.
Amit et al. () point out theoretically that adverse selection exists when venture capitals search for investment opportunities in start-up firms. Those entrepreneurs with low capabilities are willing to share their risks with outside organizations, while entrepreneurs with high capabilities like to manage firms by themselves instead of allying partners. Some young and grandstanding venture capitalists attempt to accelerate IPO of firms which they invest in by using false signals of reputation and performance. Grandstanding effect suggests that young venture capital institutes are likely to push for premature IPO of firms in which they invest in order to reap reputation as soon as possible. Such inappropriate timing of IPO will inevitably result in higher underpricing in IPO.
Megginson and Weiss () indicate that venture capital backing results in significantly lower initial returns and gross spreads, which support the certification role of venture capitalists in initial public offerings. Wong and Wong () notice that although a number of studies show that the venture capitals (VCs) can ease underpricing issues and can help ventures generate better post-IPO operational performance in the US market, they find that the effects of VC participations in Hong Kong are different. They present that the underpricing issues of VC-backed IPOs are more severe than non-VC-backed IPOs, which means that firms with VC backing have higher underpricing in IPO, which means lower IPO valuation, than those without VC backing. In sum, considering the backgrounds of our research, we offer the following hypothesis:
Hypothesis 3: The IPO valuation of entrepreneurial firms by means of the issue premium in IPO will be negatively associated with the venture capital backing measured by venture capitals existing or not; the higher the venture capital backing measured by venture capitals existing or not is, the higher the valuation of an entrepreneurial firm by means of the issue premium in IPO is.
Underwriters play a very important role in IPO, like coordinating the allocation of interests among various stakeholders. Firms prefer to choose a stronger underwriter to show a positive signal to the outsiders in order to raise more money. However, the larger or stronger an underwriter is, the greater its bargaining power becomes. Because the main revenue of underwriters comes from their underwriting fees, management fees, sales allowances, and transaction commission of stock listing, given the fixed issuing costs, underwriters will attempt to convince the IPO firms to lower their issue prices so as to reduce risks; whether new stock issue may be successful is dependent on the market conditions.
Benveniste and Spindt () suggest that underwriters have sufficient power to motivate institutional investors to disclose the authentic information they use to evaluate the values of the new IPO firms or reward them for behaving as good customers. Michaely and Shaw () prove that the higher underwriter reputation will lower IPO underpricing. Rock () and Pollock et al. () believe that underpricing is the underwriters' reward for institutional investors to undertake the risks of adverse selection or behave as good customers.
From the view of institutional investors, the stable relationships with reputable underwriters are of higher values. It is reasonable to assume that underwriters with higher reputation will be more capable of rewarding their institutional investors and therefore able to offer their clients higher IPO premiums (Bradley and Jordan ).
Hypothesis 4: The IPO valuation of entrepreneurial firms by means of the issue premium in IPO will be negatively associated with the underwriter reputation measured by the market share of each underwriter; the higher the underwriter reputation measured by the market share of each underwriter is, the higher the valuation of an entrepreneurial firm by means of the issue premium in IPO is.