Shareholders' Rights and the Effect of the Origin of Venture Capital Firms on the Underpricing of US IPOs

• Author: Samer Saade,Salim Chahine
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00857.x
• Published date: 01 November 2011
• Date: 01 November 2011

Shareholders’ Rights and the Effect of the

Origin of Venture Capital Firms on the

Underpricing of US IPOs

Salim Chahine* and Samer Saade

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper examines whether f‌irm performance at initial public offerings (IPO) is differentially

affected by the origin of Venture Capital (VC) f‌irms. Empirical investigations consider both the anti-director index and the

anti-self dealing index of the country of origin of a specif‌ic VC f‌irm as indicators for its level of legal protection of

shareholders’ rights.

Research Findings/Insights: We f‌ind that underpricing of US IPOs is negatively related to the rating of the legal protection

rights of VC f‌irms within the VC syndicate of an IPO f‌irm, and the effect is more signif‌icant in the subsampleof IPOs involving

foreign VC f‌irms. There is also evidence of a complementary role played by the legal protection rights of foreign VCs and

board independence of IPO f‌irms in reducing underpricing. Further robustness tests conf‌irm empirical f‌indings controlling

for the selection bias of IPO f‌irms by foreign VCs, and using the effect of the protection rights of the country of origin of the

lead, largest, board member, or oldest, i.e., most experienced, VC f‌irm. There is also evidence of a positive but marginally

signif‌icant effect of the legal protection rights of VC f‌irms on the long-term performance of their portfolio companies.

Theoretical/Academic Implications: Our paper suggests that the institutional framework and national legal differences

should matter in considering the effect of VC f‌irms on IPO performance. We f‌ind strong support for the institutional

perspective whereby institutional predictions were largely supported. Our results also expand on prior research on VC

syndication and show that in addition to VC monitoring, the shareholders’ protection rights of the country of origin of

foreign VC syndicate members would signal the quality of portfolio companies at IPO. Moreover, the complementary role

between the legal protection rights of the country of origin of foreign VCs and board independence indicates that f‌irm

performance is the outcome of complex mechanisms involving both f‌irm and country-level settings.

Practitioner/Policy Implications: Evidence on the association between IPO performance and the origin of VC f‌irms

suggests that policy-makers and practitioners should view legal protection of shareholders’ rights as a global issue. Since

VC investments are valuable for the development of small and medium-size enterprises, our results should contribute to

our understanding of cross-border partnering and the quality of partners within the VC industry.

Keywords: Corporate Governance, Venture Capital, Initial Public Offerings, Legal Protection Rights, Underpricing,

Institutional Theory

INTRODUCTION

Venture Capital f‌irms (VC, henceforth) in the United

States are widely seen as professional investors who

actively monitor and support their portfolio companies

(Gompers & Lerner, 2001; Jain & Kini, 1999; Lerner, 1995).

They also provide an important certif‌ication role in the IPO

process (Lin, 1996; Megginson & Weiss, 1991; Puri, 1996,

1999). VCs use various forms of control consents to better

shape the strategy/business plan of their ventures, oust the

management teams of these f‌irms prior to or following their

IPOs (Kaplan & Stromberg, 2004), and replace them with key

employees (Jain & Kini, 1999), more professional managers

(Gorman & Sahlman, 1989; Hellmann, 1998), and more inde-

pendent directors (Suchard, 2009) that reduce the principal-

agency conf‌licts of interest related to insiders’ opportunism

and increase the valueof the portfolio companies (Hellmann,

1998). While these characteristics are usually associated with

VCs in the United States,not all of them originally come from

the United States. There are many VCs active in the United

*Address for correspondence: Salim Chahine, The OlayanSchool of Business, Ameri-

can University of Beirut, Bliss Street, P.O.Box: 11-0236, Beirut – Lebanon. E-mail:

salim.chahine@aub.edu.lb

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Corporate Governance: An International Review, 2011, 19(6): 601–621

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00857.x

States thatcome from other nations, which provides a strong

test for institutionaltheory. From an institutionalperspective,

VC’s native legal institutional market would help shape the

VC’s actions in subtle but pervasive ways. In addition to

traditional agency framework, VC’s monitoring practices

and certif‌ication role may depend on the level of sharehold-

ers’ legal protection rights of their country of origin. This

paper examines the effect of legal protection rights of the

country of origin of VCs on the underpricing of IPOs in the

US.1It further investigates whether country-level legal pro-

tection rights and f‌irm-level corporate governance practices

play a complementary role which should reduce underpric-

ing of VC-backed portfolio companies.

Prior research shows evidence that differences in

national institutions and legal systems impact the effective-

ness of corporate governance on the f‌irm level (Aguilera

and Jackson, 2003; Aguilera, Filatotchev, Gospel, & Jackson,

2008; La Porta, Lopez-de-Silances, Shleifer, & Vishny, 2000,

2002), and the association between VC monitoring and IPO

performance (Bruton, Filatotchev, Chahine, & Wright,

2010). Institutional theory would argue that the effective-

ness of the monitoring role played by VC f‌irms is affected

by formal institutions, law, and regulations and their

ability to protect corporate shareholders from expropria-

tion by controlling stakeholders (La Porta, Lopez-de-

Silances, Shleifer, & Vishny, 1997), or expropriation of

minority shareholders by corporate shareholders (Claes-

sens, Djankov, Fan, & Lang, 2002; La Porta, Lopez-de-

Silanes, and Shleifer, 1999; Shleifer & Vishny, 1997;

Zingales, 1994).

Compared to the United States, foreign VCs come from

different backgrounds and are therefore subject to different

legal, institutional, and cultural frameworks. These differ-

ences could have important consequences on the VC’s legal

protection rights’ effect over the f‌irms they f‌inance. Accord-

ingly, higher legal protection rights of VC’s country of origin

should translate into a better governance effect of VCs over

their backed f‌irms and signal their good quality, which

reduces underpricing at IPO. In addition, VC investment is

a social business network, and therefore the composition of

VC syndicates provides valuable insights into the value of

portfolio companies. As such, a VC syndicate with foreign

VCs coming from countries with low shareholders’ legal

protection rights may send a bad signal on the quality of the

IPO f‌irm, which increases the risk premium, i.e., underpric-

ing, required by outside investors at IPO.

The contributions of our study are two-fold. On the one

hand, this paper expands on prior research that combines

institutional theory and agency perspective. As such, it

complements prior results in Bruton et al. (2010) showing

that multiple agency relationships are affected by different

institutional contexts. Specif‌ically, it shows evidence of the

effect of differences in national legal frameworks on the

effectiveness of the corporate governance role of VC f‌irms at

the time of IPO. Using the anti-director index (La Porta et al.,

2000) and the anti-self dealing index (Djankov, La Porta,

Lopez-de-Silanes, & Shleifer, 2008), it is the f‌irst paper to

consider the effects of legal protection rights of the country

of origin of the VC f‌irm on the underpricing of IPOs in the

US market. It also complements prior research that indicates

a lack of evidence on the performance impact of foreign

versus domestic VCs (Pruthi, Wright, & Lockett, 2003) and

the effect of the VC country of origin (Wright, Pruthi, &

Lockett, 2005). Consistent with the monitoring and certif‌ica-

tion roles played by VC f‌irms, we add to the literature on

foreign VCs. We f‌ind that VC syndicates involving foreign

VCs coming from countries with high shareholders’ protec-

tion rights (e.g., UK and Canada) are likely to improve the

overall level of governance standards of their investees.

These syndicates also send a positive signal of the quality of

the IPO f‌irm, thus reducing IPO underpricing. Our f‌indings

also conf‌irm the existence of a complementary role between

the level of shareholders’ protection rights and board inde-

pendence in affecting IPO underpricing.

On the other hand, our study contributes to prior research

on VC syndication, and suggests that the weighted average

of shareholders’ protection rights of VC investors may

ref‌lect the quality of cross-border partnering and VC

network. Although investors in the US are protected by

stringent regulations, such as Sarbanes-Oxley legislation,

and are able to sue managers who do not act in their best

interest, VCs still have the f‌lexibility to adopt or decline

specif‌ic provisions that affect the level of shareholders’ legal

protection rights (Klapper & Love, 2004). Therefore, the

choice of foreign VC partners and the governance standards

of their countries affect the risk premium required by inves-

tors at the time of IPO.

This paper is organized as follows. First, we present the

literature review and the hypotheses. Second, we describe

the data and the methodology used in this research. Third,

we discuss the empirical results and their implications, and

f‌inally, we draw some relevant conclusions.

REVIEW OF LITERATURE

AND HYPOTHESIS

Underpricing and the Legal Protection Rights of the

Country of Origin of VC f‌irms

An extensive body of research relies on the signaling theory

to explain IPO underpricing. According to this theory,

issuers send positive signals to the market about the quality

of their public offerings. Similarly, VC f‌irms might play

a certif‌ication and monitoring role that helps reduce

underpricing. While prior research concentrates on the

monitoring/certif‌ication role from a signaling perspective,

there is limited research that addresses this issue from a

legal protection rights’ perspective, particularly the effect of

the country of origin of VCs on the performance of their

portfolio companies.

Prior to funding a f‌irm, VCs undergo a screening process

to identify high growth, highly innovative, new technology,

or entrepreneurial projects, such as investment opportuni-

ties that could provide a high return if they succeed

(Gompers & Lerner, 2001; Gompers, 1995). VCs design

f‌inancial contracts to monitor and add value through

support activities (Kaplan & Stromberg, 2004). As such, they

set up corporate governancecontrol mechanisms that ensure

the success of the IPO and protect shareholders’ rights,

which in turn improve f‌irm value and reduce IPO under-

pricing (Barry et al., 1990; Chahine, Filatotchev, & Wright,

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Volume 19 Number 6 November 2011 © 2011 Blackwell Publishing Ltd