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 Business Miami University Jill R. Kickul, Ph.D., Director Stewart Satter Program in Social Entrepreneurship NYU Stern School of Business Philip Drake, Ph.D. Arizona State University
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)
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?
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
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")
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.
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
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
VC Certification Three tests that must be met before thirdparty 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 overvalued issue. 2. The value of this reputation must be greater than that which would be off-set by any onetime 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.
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 insurance argument 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.
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
Data 352 IPOs 159 VC backed and 193 non-vc backed Sued by shareholders and/or SEC for material misstatements 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
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
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
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......
Analysis of Lust Descriptives 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
Analysis of Lust Probability of Being Sued 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 Lust Charge Legitimacy and Settlement 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 Lust Descriptives and Underpricing
Table 1 Sample firm distribution across years by VC-backing & Hi-Tech definition Year Total Number of IPOs Number (%) Firms VC-backed Number (%) Hi-Tech Firms Number (%) IPOs Sued Number (%) VCbacked 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 2 Identification of the Number and Cumulative Number of VC funds or Firms Sued in Sample Number Cum Number Percentage 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 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 corporate Suits. Sprout Group [a VC fund of DLJ] was named in 13. The Cumulative is only 28 since these two funds both funded 3 companies that were sued.
Table 3 Comparative Descriptive Statistics and t-statistics for VC-Backed & Non-VC Backed, Sued & Not-Sued IPO Firms VC-Backed Underwriter rank Sued Sample Mean (Std. Dev.) 8.03 (1.39) Age of Firm 8.40 (8.85) Price Revision 0.12 (0.30) Underpricing 0.24 (0.51) Sales ($Millions) Assets ($Millions) 65.16 (190.63) 49.24 (104.86) Not-Sued Sample Mean (Std. Dev.) 7.72 (1.72) 9.24 (11.66) 0.04 (0.27) 0.31 (0.59) 50.49 (176.45) 45.87 (138.36) t-tests of Differences 2.65** -0.97 3.43** -1.27 1.00 0.32 *p<.05 **p<.01
Table 3 (cont d) Comparative Descriptive Statistics and t-statistics for VC-Backed & Non-VC Backed, Sued & Not-Sued IPO Firms Non VC-Backed Sued Not-Sued t-statistics Underwriter rank 7.12 (2.16) Age of Firm 16.65 (21.63) Price Revision -0.01 (0.18) Underpricing 0.12 (0.28) Sales ($Millions) Assets ($Millions) 244.87 (1561.02) 229.31 (1142.30) 6.59 (2.45) 16.30 (20.94) -0.01 (0.19) 0.14 (0.29) 243.39 (1342.26) 693.34 (8875.77) 3.20** 1.06 0.05-0.27 0.07-0.67 *p<.05 **p<.01
Table 4 Two-Stage Least-Squares Regression Analyses Based on Loughran and Ritter (2004) Variables Dependent Variable = Underpricing B T VIF Control Variables Constant 0.150 11.337** Pre/Post 1990 0.025 1.754 1.005 Age of Firm -0.081-5.492** 1.155 Sales ($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** R 2 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** R 2 0.09 Change in R 2 0.02** *p<.05 **p<.01
Analysis of Lust Probability of Being Sued
Table 5 Results of the 3-Stage Logit Model Estimation Panel A: Step 1 - Overall Model Fit Value -2 log likelihood 2338.74 Cox & Snell R 2 0.00 Omnibus Test of Model Coefficients Χ 2 df Sig Model 5.105 5 0.40 Nagelkerke R 2 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
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 R 2 0.00 Omnibus Test of Model Coefficients Χ 2 df Sig Model 7.695 6 0.26 Nagelkerke R 2 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
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 R 2 0.01 Omnibus Test of Model Coefficients Χ 2 df Sig Model 24.832 8 0.02 Nagelkerke R 2 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
Analysis of Lust Charge Legitimacy and Settlement
Table 6 Descriptive Statistics for Charge Legitimacy and Settlement Size for VC-Backed and Non VC-Backed Firms Average (Expected) Number Standard Deviation 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 *p<.05 **p<.01 Definition: Charge Legitimacy = 0 if all or some charges dismissed or 1 if no charges dismissed. Interpretation: Non-VC backed firms have fewer charges dismissed than expected. VC-backed firms have more charges dismissed than expected.
Table 7 Least-Squares Regression Analyses Variables Dependent 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** R 2 0.046
Table 8 Comparative Descriptive Statistics for Sued IPOs Backed by VC Firms with Different Likelihoods of Being Sued VC- Sued Infrequently VC Sued Frequently t-tests of Differences Charge Legitimacy Settlement Settlement/Net Proceeds 1.31 (0.88) 1.38 (0.83) 8,556,672 (63,429,431) 30,902,471 (148,905,914) 0.172 (0.575) 0.408 (0.182) -0.43-0.70-1.11 Definition: VC-sued infrequently means named in less than 5 corporate suits. VC-sued frequently means named in 5 or more corporate suits Interpretation: Regardless of the likelihood of being sued VC firms Fight suits and have statistically indistinguishable levels of charges dismissed and settlement levels.
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