Governance, Ownership Structure, and Performance of Entrepreneurial IPOs in AIM Companies

• Author: Chris Mallin,Kean Ow‐Yong,Hisham Farag
• Published date: 01 March 2014
• DOI: http://doi.org/10.1111/corg.12049
• Date: 01 March 2014

Governance, Ownership Structure, and

Performance of Entrepreneurial IPOs in

AIM Companies

Hisham Farag*, Chris Mallin, and Kean Ow-Yong

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: The study investigates the impact of venture capital (VC) ownership on corporate governance

characteristics in entrepreneurial companies listed on the UK’s Alternative Investment Market (AIM). In particular, the

paper examines the impact of venture capital funds on the f‌irm’s governance structure post-IPO and the dynamic inter-

relationship between corporate governance (CG), venture capital ownership and f‌inancial performance.

Research Findings/Insights: Using hand collected data from a sample of 271 entrepreneurial companies admitted to AIM

during the period 2000–2007, we measure and track the corporate governance characteristics by constructing a CGAIM50

index. Our f‌indings suggest a high level of VC ownership and its reputation leads to better corporate governance in our

sample of entrepreneurial Initial Public Offering (IPO) companies. We also f‌ind a positive and signif‌icant relationship

between corporate governance characteristics and f‌inancial performance, which suggests that outside shareholders such as

VCs bring managerial know-how and hence help improve IPO companies’ performance.

Theoretical/Academic Implications: The study is the f‌irst to examine the CG characteristicsof entrepreneurial (fast growth)

companies on the AIM using a unique index. Theinter-relationship between venture capital ownership structure, corporate

governance, and f‌inancial performance is modeled using the system GMM estimator of dynamic panel model in addition

to the 3SLS methodology.

Practitioner/Policy Implications: The study offers practical implications for regulatory authorities and investors, as it

highlights that venture capital funds investing in entrepreneurial companies on the AIM have a positive impact on both

corporategovernance and company performance, which improvesafter IPO admission, and also on subsequent performance.

Keywords: Corporate Governance, Venture Capital, Entrepreneurial Companies, Alternative Investment Market (AIM),

Ownership Structure

INTRODUCTION

The inf‌luence of ownership structure and, in particular,

of venture capital funds on the corporate governance

and performance of initial public offerings (IPOs) has

been the focus of a number of studies (Bonini, Alkan, &

Salvi, 2012; Bruton, Filatotchev, Chahine, & Wright, 2010;

Filatotchev, Wright, & Arberk, 2006; Suchard,2009). The role

of venture capital funds in promoting better, more effective

governance and hence enabling high growth in entrepre-

neurial companies is particularly important at a time when

stock markets are still recovering from the f‌inancial crisis,

and when investors may be more reluctantto invest in entre-

preneurial companies’ IPOs (often seen as more risky).

In this paper, we investigate the impact of venture capital

ownership on corporate governance characteristics of the

entrepreneurial companies f‌loated on the UK’s Alternative

Investment Market (AIM). We raise the question of whether

VCs improve the corporate governance of their investee

companies in AIM after their IPOs. As VCs usually do not

invest long term, they are motivated to improve governance

in order to maximize the exit price of their investee compa-

nies. The level of corporate governance is usually quantif‌ied

and a number of governance studies focus on a subset of

governance measures (e.g., Campbell & Frye, 2009; Konijn,

Kräussl, & Lucas, 2011; Suchard, 2009). However, this

approach may not def‌initively conclude that a particular

chosen subset is highly relevant or it may merely represent

*Address for correspondence: Hisham Farag,Birmingham Business School, University

of Birmingham, Edgbaston, Birmingham B15 2TT, UK. Tel: +44(0)-121-414-3101; Fax:

+44(0)-121-414-6678; E-mail: h.farag@bham.ac.uk

100

Corporate Governance: An International Review, 2014, 22(2): 100–115

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12049

some missing aspects of governance. We overcome this

problem by constructing a comprehensive index from a list

of items that conceivably ref‌lect good corporate governance,

covering four distinct aspects of corporate governance char-

acteristics in AIM, namely board structure, board sub-

committees, board independence, and disclosure.

Our paper also investigates whether the presence of VCs

improves the f‌inancial performance of their investee compa-

nies. VCs operate as general partners in their investment

funds and play an active role in monitoring or managing

their investee companies. As their funds usually have a

limited life (usually up to 10 years), their reputation and

credibility is important for them to raise new funds regu-

larly to remain in business. Hence, superior f‌inancial perfor-

mance of their investee companies would enhance their

reputation and make it easier to raise new funds in future.

The body of literature on the performance of VC-backed

IPOs, however, is not conclusive (e.g., Brav, Geczy, and

Gompers, 2000; Gompers and Lerner, 2003; Jain and Kini,

1995; Bruton et al., 2010).

Our research objectives are: (1) to identify corporate gov-

ernance characteristics of entrepreneurial IPOs f‌loated on

AIM; (2) to investigate the relationship between VC owner-

ship in entrepreneurial (high growth) IPO companies and

their governance characteristics; (3) to investigate the link

between governance structure and the f‌inancial perfor-

mance of the entrepreneurial IPOs; and (4) to identify the

relationship between VC ownership in entrepreneurial IPO

companies and their f‌inancial performance.

We hand collect data from a sample of 271 companies

admitted to AIM during the period 2000–2007. We measure

corporate governance characteristics by constructing a

CGAIM50 index. We also monitor the improvements, if any,

in corporate governance (CG) score for all high growth

(entrepreneurial) listed companies on AIM over 5 years

including the IPO year. We use the system GMM estimator

of dynamic panel data model in addition to two and three

stage least squares (2SLS and 3SLS) to empirically estimate a

system of simultaneous equations to examine the dynamic

relationship between corporate governance, ownership

structure, and f‌inancial performance of AIM companies.

We f‌ind that there is a signif‌icant and positive relationship

between CG characteristics (measured by CGAIM50 index)

and VC ownership; this f‌inding is consistent with the f‌ind-

ings of earlier studies (Bonini et al., 2012; Filatotchev et al.,

2006), and emphasizes the monitoring role of VCs in devel-

oping the corporate governance characteristics of the f‌irm.

Secondly, we f‌ind a causal relationship between corporate

governance (CG) and f‌inancial performance (FP). This

suggests that better f‌inancial performance leads to better

corporate governance characteristics. However, this causal

relationship mayalso imply that better corporate governance

leads to better f‌inancial performance. It infers the impor-

tance of corporate governance which may lead to better

management quality, better decision-making processes and

better f‌inancial performance accordingly. Finally, we did not

f‌ind a signif‌icant relationship between VC ownership struc-

ture and f‌inancial performance; however, we argue that

VC ownership indirectly leads to better f‌inancial perfor-

mance via its positive and signif‌icant impact on corporate

governance.

Our study makes several contributions: f‌irstly, junior

stock markets like AIM have not been well researched and

our study is the f‌irst to examine the corporate governance

characteristics of high growth entrepreneurial IPOs in AIM

using a unique index, the CGAIM50 index.

The CGAIM50 is a comprehensive governance index that

suits the nature of, and the development in, second-tier

markets. Other published governance indices are US

market-based and have less relevance to UK companies and,

in particular, to young and fast growth companies listed in

junior markets. Secondly, the paper links the entrepreneurial

companies’ governance with their VC ownership structure,

thereby enabling us to investigate the impact of venture

capital ownership on the company’s governance structure;

and f‌inally we estimate the dynamic inter-relationship

between corporate governance, ownership structure, and

f‌inancial performance.

The paper has a number of policy implications. The regu-

latory authorities and investors within AIM would be inter-

ested in whether corporate governance improves after an

IPO admission and its effect on f‌irm performance subse-

quently. The impact of venture capital ownership structure

on corporate governanceis of interest to directors and inves-

tors generally. Finallythe inter-relationship between venture

capital ownership structure, corporate governance, and

f‌inancial performance will be of interest to a varied constitu-

ency, encompassing those interested in second-tier markets

and entrepreneurial companies, those seeking to maximize

returns on their portfolios and those interested in encourag-

ing best practice corporate governance through its links to

corporate f‌inancial performance.

The remainder of the paper is structured as follows. The

next section discusses the related literature review and

development of the main hypotheses. This is followed by a

brief background and the development of the AIM. We then

present the data and the empirical models followed by the

results and the robustness tests. Finally, we conclude the

paper with a discussion of the f‌indings and the theoretical

and policy implications.

LITERATURE REVIEW AND HYPOTHESES

Theoretical Perspectives

Shareholders with concentrated holdings often play,

through their varied interests and inf‌luence, multiple roles

in their company’s pre- and post-IPO periods. The notion

that when ownership and control are separated, principals

employ governance mechanisms to reduce agency costs is

well documented (Jensen & Meckling, 1976; Rajan &

Zingales, 1995). The VC industry particularly characterizes

this multi-layered agency problem, where asymmetrical

information exists between the VCs and the founding

owners. Hence agency theorists surmise that VCs adopt

mechanisms to mitigate this. A common mechanism is to

strengthen the IPO’s governance structures through board

representation, monitoring its activities, and controlling

management to reduce the agency problem.

Entrepreneurial IPO companies invariably require specif‌ic

resources, including f‌inancial, innovative, and technical

expertise. VCs, through providing supplementary resources

GOVERNANCE, VC OWNERSHIP, AND PERFORMANCE IN IPOs 101

Volume 22 Number 2 March 2014© 2014 John Wiley & Sons Ltd