Post on 26-Mar-2018
Doctoral Track and Conference
ENTREPRENEURSHIP, CULTURE, FINANCE AND ECONOMIC DEVELOPMENT
“The Price of Lust : The Case of IPO Lawsuits against VC-Backed Firms,” Mark D. Griffiths*, Jill R. Kickul** and Philip Drake*** * Prof. Mark D. Griffiths, Jack Anderson Professor of Finance, (Miami University, Farmer School of Business –USA) griffim2@muohio.edu ** Professor, Director Stewart Satter Program in Social Entrepreneurship, NYU – Stern School of Business kickuljr@muohio.edu
THE PRICE OF LUST:THE CASE OF IPO LAWSUITS AGAINST VC-
BACKED FIRMS
Mark D. Griffiths, Ph.D.Jack Anderson Professor of Finance
Farmer School of BusinessMiami University
Jill R. Kickul, Ph.D., DirectorStewart Satter Program in
Social EntrepreneurshipNYU – Stern School of Business
Philip Drake, Ph.D.Arizona State University
Babson 2008Griffiths, Kickul & Drake
THE PRICE OF LUST . . .
“There are strange things done in the midnight sun
By the men who moil for gold;…”
The Cremation of Sam McGee
(Robert W. Service)
Babson 2008Griffiths, Kickul & Drake
Why SHOULD We Care?
The initial public offering is supposed to be the exit strategy for the VC Fund.
If the firm gets sued over the IPO, something went horribly wrong!
Are there differences between VC-backed and non-VC-backed sued IPOs?
Are there other characteristics that determine the likelihood of being sued?
What can we learn from the worst case scenario?
Babson 2008Griffiths, Kickul & Drake
Potential Charges
Section 11(1933) making a false statement in a registration document includes company directors, signees, accountants, underwriters, persons certifying statements & persons named in the document **
Section 12 (1933) same as 11 but applies to secondary market trading in the securities and so, makes brokers liable as well
Section 10b (SEC 1934) prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security, including insider trading.
FCPA – Foreign Corrupt Practices Act – not just bribery but applies to accounting practices used by companies the shares of which are listed in the United States
Common Law – used for violation of traditional business practices not specifically detailed in legislation
Other – usually mail fraud and other provisions of SEC Act
Babson 2008Griffiths, Kickul & Drake
An Example….The lawsuit asserts claims under Section 11, 12 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 . . .and seeks to recover damages. . .
In exchange for the excessive commissions, . . . lead underwriter The Goldman Sachs Group, Inc. and underwriters FleetBoston Robertson Stephens, Inc. and Merrill Lynch, Pierce, Fenner & Smith, Inc. allocated E-Loan shares to customers at the IPO price of $14.00 per share. To receive the allocations . . . at $14.00, the defendant underwriters' brokerage customers had to agree to purchase additional shares in the aftermarket at progressively higher prices. . . (a practice known on Wall Street as "laddering")
Babson 2008Griffiths, Kickul & Drake
An Example…
This artificial price inflation, . . . enabled both the defendant underwriters and their customers to reap enormous profits by buying E-Loan stock at the $14.00 IPO price and then selling it later for a profit at inflated aftermarket prices, which rose as high as $51.00 during its first day of trading. . .
the complaint alleges, the defendant underwriters required their customers to "kick back" some of their profits in the form of secret commissions. . . sometimes calculated . . . on how much profit . . . had (been) made (on the) IPO stock allocation. . .
The complaint further alleges that . . . the Prospectus distributed to investors and the Registration Statement filed with the SEC . . . contained material misstatements regarding the commissions that the underwriters would derive from the IPO and failed to disclose the additional commissions and "laddering" scheme discussed above.”
Babson 2008Griffiths, Kickul & Drake
What‟s the Problem?
The principal question in the analysis of initial public offerings [IPOs] is the ability of third parties to assess the value of securities issued by firms that were previously unknown to the market.
This problem is characterized by the asymmetric information that exists between the corporate insiders and the public investors.
What‟s the solution? Signaling of fair pricing usually through VC & underwriter certification
Babson 2008Griffiths, Kickul & Drake
VC Certification
Megginson and Weiss (1991) document that VC backing reduces both the mean & median underpricing and reduces the underwriting spread
[Disputed by Arthurs, Hoskisson, Busenitz & Johnson (2008)]
M&W find support for the VC certification hypothesis by finding that VC backed issuers:
Attract more prestigious auditors and underwriters than non-VC backed firms;
VC backed firms elicit greater interest from institutional investors and can go public at an earlier age and,
The credibility of the VC‟s information is enhanced by the fact that they are major shareholders prior to the IPO and retain significant portions of their holdings after the offer
Babson 2008Griffiths, Kickul & Drake
VC Certification
Three tests that must be met before third-party certification is seen to be credible and legitimate
1. The certifying agent must be risking a sufficiently significant reputation that would be lost or severely impugned by endorsing an over-valued issue.
2. The value of this reputation must be greater than that which would be off-set by any one-time side-payment for providing a false certification.
3. It must be costly to the issuing firm to purchase these certifying services and this cost must be increasing with respect to and the potential importance of the asymmetrical information and its affect on the value of securities being issued.
Babson 2008Griffiths, Kickul & Drake
Analyst Lust Loughran and Ritter (2004) introduce the analyst
lust hypothesis to describe IPO underpricing where influential analysts are engaged to take the firm public creating incentives to seek underwriters with a reputation for severe underpricing.
We test the Loughran and Ritter hypotheses on underpricing as well as the Lowry & Shu (2002) finding that greater underpricing leads to lower litigation risk. This is essentially an insuranceargument
We also investigate both the VC-backed success hypothesis (Jain & Kini, 2000) and the Huneycutt & Wibker (1992) wisdom of “sue the party with the deepest pockets.”
Babson 2008Griffiths, Kickul & Drake
Where‟s the Lust?
Management has the long term view with respect to the viability of the firm.
VC funds, agents for their fund investors, have to show an appropriate return and live 5-8 years
Underwriters are long term agents of their clients and have the shortest term view
Ultimate shareholders have an indeterminant view
But, there‟s „a lot of money left on the table‟
Babson 2008Griffiths, Kickul & Drake
Data
352 IPOs 159 VC backed and 193 non-VC backed Sued by shareholders and/or SEC for material mis-
statements Our control sample is 6154 IPOs that were not sued over
the same time period.
Sample is taken from Thomson Financial‟s SDC New Issues database January 1982 - December 2001
Segment and accounting data (including sales and assets information) Compustat‟s segment files New issues are matched to the file to compare VC
versus non-VC backed characteristics
Babson 2008Griffiths, Kickul & Drake
Data
Controls variables match Loughran & Ritter (2004) Firm age (pre-IPO) measured in terms of
years
log-transformed to account for skewness
Firm size
Assets and sales in the year prior to IPO
High technology industry
SEC Hi-tech Definitions
IPO pre-90 or post-90
Babson 2008Griffiths, Kickul & Drake
Data
A dummy variable was created to indicate whether a firm had received venture capital backing or not.
A dummy variable was created to indicate the number of times certain VC funds were sued within the sample.
Dummy variable =1 if VC was sued 5 or more times and zero if sued less than 5 times over the sample period
Babson 2008Griffiths, Kickul & Drake
Data
Underpricing
% change in stock price during the first day of trading for the IPO
((closing price – offer price)/offer price)
Offer price revision
Divide the final offer price by the mid-point of the initial offer price range & subtract one. The range is stated in the IPO prospectus.
Carter & Manaster underwriter rankings . . . . . .
Babson 2008Griffiths, Kickul & Drake
Analysis of LustDescriptives and Underpricing
1. Distribution of IPO Firms Over 20-year period
2. Identification of number of VC Firms Sued
3. Comparative Descriptive Statistics
1. VC-Backed, Non-VC Backed, Sued, Not Sued IPO Firms
4. Two-stage least-squares regression analyses
1. Predictors: Controls variables are: (1) Underwriter Rank and VC-Backed (2)
2. Dependent Variable: Underpricing
Babson 2008Griffiths, Kickul & Drake
5. Three-stage Logit Model Estimation
Predictors: Controls (stage 1), Underpricing (stage 2), and Underwriter Rank & VC-Backed (stage 3)
Dependent Variable: Sued
Analysis of LustProbability of Being Sued
Babson 2008Griffiths, Kickul & Drake
6. Descriptive statistics for charge legitimacy and settlement size (by VC)
7. Least-square regression analyses
Predictors: Underwriter Rank, VC-Backed, Underpricing
Dependent Variable: Settlement Size
8. Comparative Descriptive Statistics
VC sued infrequently/frequently by charge legitimacy and settlement
Analysis of LustCharge Legitimacy and Settlement
Year Total Number of IPOs
Number (%) FirmsVC-backed
Number (%) Hi-Tech Firms
Number (%)IPOs Sued
Number (%) VC-backed IPOs Sued
Number (%)Hi-Tech Firms
Sued
1982 31 11 (35.5) 11 (35.5) 5 (16.1) 1 (20.0) 2 (40.0)
1983 499 132 (26.5) 130 (26.1) 30 (6.0) 12 (40.0) 12 (40.0)
1984 204 55 (27.0) 41 (20.1) 12 (5.9) 5 (41.7) 4 (30.0)
1985 211 49 (23.2) 27 (12.8) 12 (5.7) 5 (41.7) 0 (0.0)
1986 463 102 (22.0) 57 (12.3) 21 (4.4) 6 (28.6) 1 (4.8)
1987 312 85 (27.2) 49 (15.7) 6 (1.9) 1 (16.7) 1 (16.7)
1988 119 35 (29.4) 20 (16.8) 5 (4.2) 3 (60.0) 1 (20.0)
1989 113 40 (35.4) 24 (21.2) 10 (8.8) 2 (25.0) 2 (25.0)
1990 110 45 (40.9) 25 (22.7) 10 (9.1) 5 (50.0) 2 (50.0)
1991 276 125 (45.3) 47 (17.0) 26 (9.4) 11 (42.3) 4 (15.4)
1992 393 165 (42.0) 64 (16.3) 30 (7.6) 18 (4.6) 10 (2.5)
1993 496 197 (39.7) 96 (19.4) 41 (8.3) 24 (58.5) 16 (39.0)
1994 390 137 (35.1) 80 (20.5) 16 (4.1) 6 (37.5) 3 (18.8)
1995 436 184 (42.2) 161 (36.9) 23 (5.3) 10 (43.5) 10 (43.5)
1996 626 251 (40.1) 188 (30.0) 33 (5.3) 13 (39.4) 12 (36.4)
1997 417 128 (30.7) 118 (28.3) 23 (5.5) 7 (30.4) 9 (39.1)
1998 257 78 (30.4) 84 (32.7) 18 (7.0) 8 (44.4) 5 (27.8)
1999 417 256 (61.4) 235 (56.4) 13 (3.1) 10 (76.9) 6 (46.2)
2000 313 225 (71.9) 156 (49.8) 13 (4.2) 9 (69.2) 7 (53.8)
2001 71 35 (49.3) 19 (26.8) 5 (7.0) 3 (60.0) 2 (40.0)
Totals 6154 2335 (37.9) 1632 (26.5) 352 (5.7)
159(45.2)
109(31.0)
Table 1Sample firm distribution across years by VC-backing & Hi-Tech definition
Number Cum NumberPercentage
of Cum
Percentage
of Cases of Cases Total Cases of Total Cases
1 J.P. Morgan Partners (Chase Capital) 18 18 2.2 2.2
2 Sprout Group 13 28 1.6 3.9
3 Kleiner Perkins Caufield & Byers 11 34 1.4 5.2
4 New Enterprise Associates 11 40 1.4 6.6
5 Sequoia Capital 10 44 1.2 7.8
6 TA Associates, Inc. 9 52 1.1 9.0
Table 2Identification of the Number and Cumulative Number
of VC funds or Firms Sued in Sample
Of the remaining 422 VC Funds/Firms 8 were named in connection with 7 companies, 4 were named in connection with 6 sued firms, 13 were named in connection with 5 companies, 15 were named in connection with 4 companies, 37 were named in connection with 3 firms, 71 were connected with 2 suits and the remaining 274 were connected with 1 suit.
Interpretation: J.P. Morgan Partners were named as defendants in 18 corporateSuits. Sprout Group [a VC fund of DLJ] was named in 13. The Cumulative is only28 since these two funds both funded 3 companies that were sued.
Babson 2008Griffiths, Kickul & Drake*p<.05 **p<.01
Table 3Comparative Descriptive Statistics and t-Statistics for
VC-Backed & Non-VC Backed, Sued & Not-Sued IPO Firms
VC-Backed Sued SampleMean (Std.
Dev.)
Not-Sued SampleMean
(Std. Dev.)
t-tests of Differences
Underwriter rank
8.03 (1.39)
7.72 (1.72)
2.65**
Age of Firm 8.40 (8.85)
9.24 (11.66)
-0.97
Price Revision 0.12 (0.30)
0.04 (0.27)
3.43**
Underpricing 0.24 (0.51)
0.31 (0.59)
-1.27
Sales ($Millions)
65.16 (190.63)
50.49(176.45)
1.00
Assets ($Millions)
49.24(104.86)
45.87(138.36)
0.32
Babson 2008Griffiths, Kickul & Drake*p<.05 **p<.01
Table 3 (cont’d)Comparative Descriptive Statistics and t-Statistics for
VC-Backed & Non-VC Backed, Sued & Not-Sued IPO Firms
Non VC-Backed Sued Not-Sued t-Statistics
Underwriter rank
7.12 (2.16)
6.59(2.45)
3.20**
Age of Firm 16.65 (21.63)
16.30(20.94)
1.06
Price Revision -0.01 (0.18)
-0.01(0.19)
0.05
Underpricing 0.12(0.28)
0.14(0.29)
-0.27
Sales ($Millions)
244.87(1561.02)
243.39(1342.26)
0.07
Assets ($Millions)
229.31(1142.30)
693.34(8875.77)
-0.67
Babson 2008Griffiths, Kickul & Drake*p<.05 **p<.01
Table 4Two-Stage Least-Squares Regression Analyses
Based on Loughran and Ritter (2004)
VariablesDependent Variable = Underpricing
B T VIF
Control Variables
Constant 0.150 11.337**
Pre/Post 1990 0.025 1.754 1.005
Age of Firm -0.081 -5.492** 1.155
Sales ($Millions) -0.017 -0.081 2.164
Assets ($Millions) 0.024 1.177 2.087
High Tech Industry 0.229 16.131** 1.109
F 65.55**
R2 0.07
Predictors B T VIF
Underwriter Rank 0.11 7.741** 1.214
VC-Backed 0.13 9.441** 1.125
F 66.40**
R2 0.09
Change in R2 0.02**
Babson 2008Griffiths, Kickul & Drake
Table 5Results of the 3-Stage Logit Model Estimation
Panel A: Step 1 - Overall Model Fit Value
-2 log likelihood 2338.74
Cox & Snell R2 0.00
Omnibus Test of Model Coefficients Χ2 df Sig
Model 5.105 5 0.40
Nagelkerke R2 0.00
Hosmer & Lemeshow’s goodness-of-fit test 4.912 8 0.77
Step 1 Variables B SE Wald stat df Sig Exp(B)
Constant -2.466 0.136 330.623 1 0.00 0.085
90sDum -0.075 0.125 0.359 1 0.55 0.928
FirmAge 0.000 0.003 0.008 1 0.93 1.000
Sales 0.000 0.000 1.371 1 0.24 1.000
Assets 0.000 0.000 0.664 1 0.42 1.000
HiTechDum -0.171 0.125 1.860 1 0.17 0.843
Babson 2008Griffiths, Kickul & Drake
Table 5 (cont’d)Results of the 3-Stage Logit Model Estimation
Panel B: Step 2 - Overall Model Fit Value
-2 log likelihood 2336.15
Cox & Snell R2 0.00
Omnibus Test of Model Coefficients Χ2 df Sig
Model 7.695 6 0.26
Nagelkerke R2 0.00
Hosmer & Lemeshow’s goodness-of-fit test 4.132 8 0.85
Step 2 Variables B SE Wald stat df Sig Exp(B)
Constant -2.385 0.144 273.625 1 0.00 0.092
90sDum -0.069 0.125 0.303 1 0.58 0.934
FirmAge -0.001 0.004 0.046 1 0.83 0.999
Sales 0.000 0.000 1.328 1 0.25 1.000
Assets 0.000 0.000 0.651 1 0.42 1.000
HiTechDum -0.219 0.128 2.899 1 0.09 0.804
UnderPricing -0.245 0.163 2.245 1 0.13 0.783
Babson 2008Griffiths, Kickul & Drake
Table 5 (cont’d)Results of the 3-Stage Logit Model Estimation
Panel B: Step 3 - Overall Model Fit Value
-2 log likelihood 2319.01
Cox & Snell R2 0.01
Omnibus Test of Model Coefficients Χ2 df Sig
Model 24.832 8 0.02
Nagelkerke R2 0.01
Hosmer & Lemeshow’s goodness-of-fit test 7.253 8 0.51
Step 2 Variables B SE Wald stat df Sig Exp(B)
Constant -3.252 0.291 124.680 1 0.00 0.039
90sDum -0.039 0.125 0.096 1 0.76 0.962
FirmAge -0.002 0.004 0.401 1 0.53 0.998
Sales 0.000 0.000 1.439 1 0.23 1.000
Assets 0.000 0.000 1.234 1 0.27 1.000
HiTechDum -0.179 0.133 1.803 1 0.18 0.836
UnderPricing -0.333 0.169 3.908 1 0.05 0.717
UnderwriterRank 0.120 0.032 14.095 1 0.00 1.127
VC-backed -0.020 0.129 0.023 1 0.88 0.981
Babson 2008Griffiths, Kickul & Drake
*p<.05 **p<.01
Table 6Descriptive Statistics for Charge Legitimacy and
Settlement Size for VC-Backed and Non VC-Backed Firms
Average (Expected) Number
StandardDeviation
Non-VC Charge Legitimacy 50 (E[43])
Average Settlement $4,585,891 $8,478,063
Settlement/Proceeds 0.22 0.69
VC Charge Legitimacy 44 (E[51])
Average Settlement $4,611,431 $8,498,673
Settlement/Proceeds 0.26 1.14
Definition: Charge Legitimacy = 0 if all or some charges dismissedor 1 if no charges dismissed. Interpretation: Non-VC backed firms have fewer charges dismissedthan expected. VC-backed firms have more charges dismissed thanexpected.
Babson 2008Griffiths, Kickul & Drake
Table 7Least-Squares Regression Analyses
VariablesDependent Variable =
Settlement Amount/Proceeds
Independent Variables b t Sig.
Constant 2.293 0.02
90sDum -0.438 -3.487 0.00
FirmAge 0.003 0.997 0.32
Sales -0.000 -0.240 0.81
Assets -0.000 0.070 0.94
HiTechDum 0.010 0.075 0.94
UnderPricing 0.584 0.160 0.01
UnderwriterRank -0.035 -0.063 0.32
VC-backed 0.072 0.037 0.60
F 2.607**
R2 0.046
Babson 2008Griffiths, Kickul & Drake
Table 8Comparative Descriptive Statistics for Sued IPOs
Backed by VC Firms with Different Likelihoods of Being Sued
Charge Legitimacy Settlement Settlement/Net Proceeds
VC- Sued Infrequently
1.31(0.88)
8,556,672(63,429,431)
0.172(0.575)
VC – Sued Frequently
1.38(0.83)
30,902,471(148,905,914)
0.408(0.182)
t-tests of Differences
-0.43 -0.70 -1.11
Definition: VC-sued infrequently means named in less than 5 corporatesuits. VC-sued frequently means named in 5 or more corporate suitsInterpretation: Regardless of the likelihood of being sued VC firmsFight suits and have statistically indistinguishable levels of chargesdismissed and settlement levels.
Babson 2008Griffiths, Kickul & Drake
Discussion VC provides certification & signaling of pricing
credibility …..but underwriter rank is a better signal of getting
smaller settlements & charges dismissed
VC funds have shorter lives than Underwriters hence are pressured to show short-term gains leading to underpricing …..but underwriters are short-term agents themselves
in this market
Suing shareholders have incentive to sue VC backed firms and their underwriters because of deep pockets …..but it comes at a cost
VC have incentive to maintain ties to prestigious underwriters leading to need to defend their reputations in lawsuits