Pre-IPO Ownership Structure and Its Impact on the IPO Process

Pre-IPO Ownership Structure and Its Impact on the IPO Process

                                          ARASH ALAVI
                                        Macquarie Bank

                                      PETER KIEN PHAM*
                                        TOAN MY PHAM
             School of Banking and Finance, University of New South Wales

                                          ABSTRACT

     This paper investigates the impact of pre-IPO ownership structure on the proportion,
allocation, and pricing of new issued shares, as well as the costs of going public. We find
that retaining control is an important consideration for pre-IPO owners/managers. Where
the pre-IPO ownership of managers indicates their highest sensitivity to control dilution,
the firm issues the least shares and the new shares are not allocated in favor of new large
shareholders. We also find that larger pre-IPO shareholdings create an incentive for
managers to reduce the total cost of the issue. These results highlight the significance of
recognizing that prior to going public, private firms are not always wholly owned by
managers. Low pre-IPO ownership concentration can therefore result in agency problems
that affect key decisions in the IPO process.

*
  Corresponding author. Address: School of Banking and Finance, University of New South Wales,
Kensington NSW 2052, Australia. Email: p.pham@unsw.edu.au.
We wish to thank Balasingham Balachandran, Douglas Cumming, Petko Kalev, Simona Mola, Kathryn
Wong, Jason Zein, as well as seminar/conference participants at Monash University, the Financial
Management Association 2006 Annual Meeting, and the 30th Anniversaries of the Journal of Banking and
Finance Conference for their comments on earlier drafts of the paper. All errors remain our own.

1. INTRODUCTION

    The initial public offer (IPO) fundamentally alters many characteristics of a firm, but

none more so than its ownership structure. An immediate consequence of issuing shares

through an IPO is the greater dispersion of shareholdings. Further substantial changes in

ownership structure are also documented for many years after listing (Brennan and Franks,

1997; Mikkelson, Partch and Shah, 1997). These changes have a profound effect on

managerial incentive and control considerations (Jensen and Meckling, 1976; Zingales,

1995), and to some extent, have been linked to observed anomalies in IPOs, such as

underpricing and underperformance (Jain and Kini, 1994; Booth and Chua, 1996; Pham,

Kalev and Steen, 2003). However, most previous studies examining this critical juncture of

a firm’s ownership evolution have often focused only on the shareholding structure that

emerges after listing and largely ignored the one that exists prior to the going public

decision. Before the IPO, private firms are not always wholly owned by managers or

entrepreneurs, and hence, agency problems are not exclusive to public corporations (Ang,

Cole and Wuh Lin, 2000). That pre-IPO managerial incentive and control considerations

can influence the IPO process is therefore a plausible possibility, which due to the lack of

private firms’ ownership data has so far not been thoroughly investigated.

    In this study, we investigate the divergence of interests in private firms and its potential

impact upon IPO decisions using a sample of Australian IPOs. This sample facilitates

access to unique and extensive ownership disclosure by Australian firms to both the

Australian Securities and Investment Commission (when they remain private) and to the

Australian Stock Exchange (when they go public), so that pre-IPO ownership structure can

be accurately calculated. Among the important IPO decisions, we examine the proportion

and allocation of new shares offered to the public, and find that these decisions are

                                               1

influenced by pre-IPO owners/managers’ desire to retain control at the completion of the

IPO. Pre-IPO ownership structure is important in this regard because in many cases where

going public firms are not wholly owned by managers, it may not be possible to retain

control after listing. We also examine whether pre-IPO ownership structure may also

influence the decisions on the pricing and costs of the issue, and find that the smaller the

pre-IPO shareholdings of managers, the lower their incentive to control total issuing costs.

Our evidence thus indicates that firms may suffer from agency problems even before they

go public.

    These findings contribute to the relatively sparse line of research (e.g., Ang, et al.

(2000)) which highlights that the divergence of interests among firm owners can exist even

before going public. Specifically, in firms that are not wholly owned before going public,

key decisions in the IPO process appear to largely serve the interests of the managers. Our

findings also highlight control retention after listing as a primary concern of managers. This

is in line with the well established literature that attributes the desire for control to the

ability to enjoy private benefits (Barclay and Holderness, 1989; Zingales, 1995; Dyck and

Zingales, 2004). While previous empirical evidence has documented private benefits in

public corporations, we show that control considerations can exist as early as the pre-going

public stage. Using survey methodology, Brau and Fawcett (2006) also find that that

maintaining control is the most important issue for pre-IPO owners in deciding whether or

not to go public.

    In our study, control motives are first observed by examining the proportion of shares

offered in the IPO. Fundamental corporate finance theories stipulate that the amount raised

should be determined on the basis of the need to finance capital expenditure and exploit

growth opportunities. In addition, Pagano, Panetta and Zingales (1998) find that firms go

                                              2

public in order to reduce their leverage. Further, the proportion of shares offered to the

public, being the opposite of the pre-IPO owners’ retention rate, can serve as a signal to the

market about firm quality (Leland and Pyle, 1977; Keloharju and Kulp, 1996). After

controlling for these considerations, we find that the proportion of shares on offer is also

dependent upon pre-IPO ownership following a non-linear relation that highlights the

importance of control considerations of managers. In particular, when pre-IPO managerial

ownership levels are very high, IPO firms are likely to issue a lot of shares, because

managers are still likely to be able to retain control at the completion of the IPO. When pre-

IPO managerial ownership levels are very low, IPO firms are also likely to issue a large

proportion of shares, because managers are unlikely to be able to retain control of voting

rights after the IPO anyway. In contrast, when managers own shares in the range close to a

control threshold before the IPO (e.g., about 60 percent of equity), they are reluctant to

issue many shares, as doing so is likely to result in a loss of absolute control at the

completion of the IPO.

    The pre-IPO owners’ ability to control the firm at the completion of the IPO also

depends on the allocation of IPO shares, as control might be diminished or challenged if the

new shares are allocated in favor of large shareholders. Given that it is often difficult to

form large shareholdings in the secondary market (Shleifer and Vishny, 1986), the initial

allocation decision is thus crucial to the determination of the final ownership and control

structures. The empirical evidence on the allocation of IPO shares is inconsistent. On the

one hand, Benveniste and Spindt (1989) and Stoughton and Zechner (1997) argue that large

shareholders are favored in an allocation process because of certain benefits associated with

their presence, such as greater demand for IPO shares and improved monitoring. On the

other hand, Brennan and Franks (1997) argue that, by favoring small shareholders

                                              3

managers are better protected from hostile control challenges. Our investigation indicates

that the desire to retain control is indeed an important dimension of the allocation decision.

In particular, where it is difficult for pre-IPO owners/managers to retain control at the

completion of the IPO, newly issued shares are allocated in such a way that prevents the

emergence of large outside shareholders.

    In addition to control considerations, we also examine the impact of pre-IPO ownership

structure on the incentive to reduce the costs of going public, starting with underpricing.

Ljungqvist and Wilhelm (2003) view underpricing as evidence of agency costs because

CEOs are merely agents acting on behalf of pre-IPO shareholders when bargaining over the

issue price with the underwriters. Therefore, as the ownership of managers increases, one

would that they exert greater effort to monitor of underwriters and reduce underpricing.

Their empirical results however only support this prediction for high-tech firms during the

“dot-com bubble” period. Similar to Ljungqvist and Wilhelm (2003), we also find that

underpricing is not significantly influenced by the level of pre-IPO managerial ownership,

but that it is significantly and negatively related to the proportion of existing shares sold by

owners/managers at the IPO.

    We investigate this rather puzzling result further by taking the view that underpricing

does not represent the total cost of going public. According to Habib and Ljungqvist

(2001), the negative impact of underpricing on pre-IPO owners’ wealth may be minimal

when only a small percentage of shares is offered to the public, or when underpricing is

intentionally used as an advertising mechanism to reduce other promotion costs (e.g.

underwriting and offer management fees). Similarly, Loughran and Ritter (2002) suggest

that issuers may not be upset about “leaving money on the table” if they retain a large

proportion of shares. According to their prospect-theory based explanation, while

                                               4

underpricing is an opportunity cost (i.e., the ownership of pre-IPO shareholders is

unnecessarily diluted), it is accompanied by the good news of an increase the value of the

retained shares. If this wealth gain is sufficiently large, issuers are likely to be more fixated

on the net change in their wealth than underpricing as a single component.

    Consistent with the above arguments, we find that the existence of agency problems is

most observable through the direct costs of going public rather than underpricing, which is

an opportunity cost. Managers are only concerned about underpricing to the extent that they

stand to lose directly and immediately from it, that is, when pre-IPO owners sell their

existing shares at the IPO. Further, firms with lower pre-IPO managerial ownership tend to

have less control on promotion expenses. They also have a higher overall wealth loss from

the IPO, which is a measure constructed by Habib and Ljungqvist (2001) to depict the total

cost of going public. Overall, our results also indicate that managers with large pre-IPO

shareholdings seem to focus their effort on controlling the most direct, out-of-pocket costs.

This may be done at the expense of the overall firm’s interests, as the lack of marketing

results in a smaller shareholder base after the IPO, which may adversely affect secondary

market liquidity and cost of capital.

    The rest of the paper is structured as follows. Section 2 introduces the sample and

elaborates the variable design. Section 3 and 4 investigate the impact of pre-IPO ownership

structure on the funding and allocation decisions, respectively. Section 5 analyzes whether

pre-IPO ownership provides managers with an incentive to control underpricing and other

issuing costs. Section 6 concludes and discusses the implications of our research.

                                               5

2. DATA AND VARIABLE CONSTRUCTION

3.1. Description of the Sample

    The sample used for this study is composed of 555 industrial IPOs that went public on

the Australian Stock Exchange (ASX) in the period January 1995 to December 2005,

excluding public offers of unit trusts and stapled securities. Mining companies are also

excluded as they often issue no-liability shares and feature unique ownership structures for

the purpose of dealing with risky mineral exploration (Pham et al., 2003). We also remove

IPOs of privatized government-owned companies because their motives for going public,

number of shares sold and issue price may be influenced by public policies and political

aims. Finally, six other firms were removed because our three data sources for ownership

structure (see below) could not identify their pre-IPO owners. The remaining dataset

consists of 555 IPOs. Information about these firms and their issue characteristics are

obtained mainly from the prospectuses stored in the Connect 4 database.

2.2. Measuring Pre-IPO Ownership Structure

    In the corporate finance literature, the divergence of interests between owners and

managers is often examined after rather than before the firm goes public. However, in the

rare cases where private firms’ data can be obtained, as in Ang, et al. (2000), they show

that shareholding structures of these firms can be quite diverse, and agency costs are clearly

observable in those with low ownership concentration. Australian IPOs offer such an

opportunity to construct accurate measures of pre-IPO ownership structure and study its

impact on a number of important IPO decisions. In particular, Australian IPOs are required

to report certain ownership information to the Australian Stock Exchange (ASX) before and

after the allotment of shares in their prospectuses and pre-quotation disclosure statements,

                                              6

which are obtained from the Connect 4 and DatAnalysis databases.1 In the years before

going public, the private predecessor of the IPO entity also has to disclose its shareholding

structure to the Australian Securities and Investment Commission (ASIC). Where

necessary, we obtain the summary of this information, which contains the equity ownership

of up to 20 largest shareholders, from the Dun and Bradstreet Australia’s Credit Gate

database.

    By combining these two disclosure requirements, we are able to avoid a number of

significant problems associated with constructing pre-IPO ownership structure. First,

shareholdings may be double-counted if prospectuses are the only source of ownership

information. For example, if a venture capital fund has a non-executive director as its

representative on the board, both the fund and the director may report the same relevant

interest in the firm’s equity. We address this problem by cross-checking with the ownership

information of the IPO firm’s private predecessor reported to ASIC, which is based on

direct rather than relevant interests of individual shareholders.

    Second, pre-IPO ownership concentration can be understated if there are related-party

transactions that occur concurrently with or are contingent upon the public offer. For

example, many IPOs in our sample use their offer proceeds to acquire other businesses

owned by their pre-IPO owners/managers. In some cases, the IPO entity is only a front

company/listing vehicle used to facilitate the simultaneous merger and listing of several

related businesses. If an IPO employs such transactions, the pre-IPO ownership structure as

disclosed in its prospectus is only relevant to the IPO entity and not representative of the

true equity interests of its pre-IPO owners in all of the businesses that combine into the

1
  All Australian prospectuses disclose equity interests of directors and some disclose interests of large
shareholders. The pre-quotation disclosure statement contains a list of the 20 largest shareholders that emerge
after the allotment of shares.

                                                      7

actual listed firm. When dealing with such a case, we rely on private firm disclosure to

ASIC to obtain the ownership information of the individual businesses, which is then

combined together to construct the overall pre-IPO ownership structure of the going public

firm.

    Our sample of Australian IPOs also facilitates the construction of post-IPO ownership

structure. In particular, we rely on the pre-quotation disclosure statement to identify the 20

largest shareholders that emerge immediately after the allotment of shares.2 We then use

this information to calculate the precise changes in the number of shares held by individual

pre-IPO managers and large shareholders, which arise due to many transactions that occur

concurrently with the IPO such as a sale (or selective cancellation/buy-back) of existing

shares, subscription to new shares, and exercising of options. The comparison of ownership

structures before and after the allotment of shares also allows us to identify the presence

and ownership of new large shareholders.

    To depict the pre-IPO ownership structure of a going public firm, we first construct the

number of original (or pre-IPO) shares. These comprise (1) shares on issue prior to the

subscription of new shares, (2) shares held by pre-IPO owners as a result of conversion of

convertible notes (or options) and private share issues that occur concurrently with the

public offer, and (3) shares of other related businesses that merge with the IPO entity

during the IPO process. We then calculate the fraction of original shares held by pre-IPO

insiders (labeled INSIDER).3 Following Barhart and Rosenstein (1998), insiders are defined

as shareholders with day to day decision making authority, including the CEO, founder(s),

2
 In this study, we use the allotment of shares to define the completion of the IPO process.
3
  Note that, it is not common for Australian companies to issue dual class shares, and thus the sample only
contains firms with a one-share-one-vote single class shares. Therefore, the terms shareholdings, voting
shares, and equity interests will be used interchangeably hereafter.

                                                    8

executive directors, and other senior managers. Non-executive directors are excluded from

this definition, unless they are also the founders.

    Other non-managerial pre-IPO owners can be categorized into two groups: major

capitalists and other small shareholders. The former is important fund providers such as

venture capital funds, angel investors, parent companies, and joint-venture partners. Some

common examples of the latter group include employees, small business partners, and

members of cooperatives and associations that are corporatized. While these shareholders

are not involved in the day-to-day decision making process, we expect that some of the

major capitalists play a significant monitoring role and may even participate in determining

IPO strategies. In addition, according to Mikkelson, et al. (1997), non-managerial pre-IPO

owners have a stronger intention to exit from their investments after the IPO than their

managerial counterparts.

    By using the combination of prospectuses and private firm disclosure to ASIC, we are

able to identify the 20 largest shareholders before the IPO. However, when testing the

impact of pre-IPO ownership structure upon key IPO decisions in a regression framework,

we cannot include both the aggregate ownership of insiders and that of all the largest non-

managerial shareholders (which would proxy for their monitoring incentive) in the same

regression due to their high correlation (the sum of these two variables is often closed to

one). Instead, we examine two alternative regression models where the presence of the

influential capitalist is accounted for, without referring explicitly to their total ownership.

The first combines the INSIDER variable with a dummy variable (labeled CAPDUMMY)

indicating the presence of a capitalist who has at least a partial controlling interest (i.e. 20%

                                               9

of pre-IPO issued shares and above).4 The second replaces CAPDUMMY with a different

dummy variable (labeled VENDUMMY), which takes value of one if at least one of the

major capitalists is a venture capital fund, and zero otherwise. These specifications are less

susceptible to the aforementioned multicolinearity problem, but still                capture the

possibilities that a shareholder with more than 20% of pre-IPO shares have a significant

control of voting rights and that venture capitalists can exert influence beyond their voting

rights through certain conditions (in the “term sheet”) set out in earlier funding rounds. This

also accounts for the possibility that major capitalists, especially venture capital funds, may

be more concerned about exiting quickly rather than securing long-term control. In this

study, we identify venture capital (or private equity) funds among the pre-IPO owners by

using information from the Australian Private Equity and Venture Capital Association

Limited, the financial press, and private firms’ profiles obtained from Dun and Bradstreet.

2.3. Measuring Secondary Sales of Pre-IPO Owners

    In an IPO, the ownership of the original owners is diluted through the issue of new (or

primary) shares and the sale of existing (secondary) shares. According to Habib and

Ljungvist (2001) and Ljungqvist and Wilhelm (2003), the latter type of transaction

represents an immediate (partial) exit of the original owners, and thus can have a more

direct influence on their incentive to control the overall issue costs than their pre-IPO

ownership. These papers use the term to ‘participation rate’ to describe the proportion of

existing shares being sold directly to the public.

    A secondary sale however can be viewed negatively by potential investors as it may

reflect a lack of commitment by the original owners. As a result, a number of IPOs use

4
 We also employ an alternative definition of CAPDUMMY using the 50% ownership level as the cut-off
point. This does not materially alter our findings and main conclusions.

                                               10

other transactions to achieve the same result of immediate exit without having to make a

more obvious declaration of a secondary sale. These involve using the offer proceeds to

buy back old shares or to acquire related businesses owned by the original owners. The net

effect is the same as a secondary sale, that is, cash in the pocket of the original owners, but

the disclosure is often in the fine print. Thus, to construct an all-inclusive measure of

secondary sales, we calculate the number of shares being sold directly to the public as the

total amount of cash received by the original owners from the IPO divided by the offer

price. This is then scaled by the number of original shares. We construct this measure

separately for insiders and major capitalists, labeled EXECSALE and CAPSALE,

respectively.

2.4. Descriptive Statistics

    Table 1 reports the descriptive statistics of the sample IPOs. To highlight the

generalizibility of our results, we draw some comparisons between Australian and US

IPOs. Australian IPOs are of slightly younger age and smaller size than their US

counterparts. For our sample, the average offer proceed is A$35 million and the average

firm age of about 11 years. By comparison, Habib and Ljunqvist (2001) and Ljungqvist and

Wilhelm (2003) report that the average offer proceed of US IPOs is about US$37 million

and US$93 million for the periods of 1991-1995 and 1996-2000, respectively. The average

firm age of their samples is around 13 years. In terms of transaction characteristics, there

are some notable similarities between Australian and US IPOs. In our sample, the number

of shares offered to the public on average makes up about a third of the total number of

post-listing issued shares. This is similar to the float ratio reported by Habib and Ljunqvist

(2001) for their US sample. The proportion of existing shares sold as a secondary sale in

                                              11

our study is about 8%. In Habib and Ljunqvist (2001), the average for the equivalent

measure (i.e., the participation ratio) is 7%. The average market-adjusted underpricing for

our sample is about 25%, which is within the range of 14% reported by Habib and

Ljunqvist (2001) and 36% reported by Ljungqvist and Wilhelm (2003) for US IPOs.

    Panels A and B of Table 2 show the ownership structures immediately before and after

the IPO. Managerial shareholdings fall from an average of 45.97% to 30.18%. The table

also shows similar decline in the percentage ownership of major capitalists from 24.92% to

19.80%. This ownership dilution is a result of both the issue of new shares and the

secondary sale of existing shares. With the latter transaction, insiders and major capitalists

dispose on average 3.16% and 5.11% of original shares, respectively. The larger than

average secondary sales by major capitalists in spite of their smaller than average pre-IPO

percentage shareholdings thus indicate that non-managerial capitalists are more inclined to

make an immediate exit through the IPO than insiders. Another notable observation is that

on average the pre-IPO insiders and major capitalists hold slightly less than 50% of issued

shares. Without a controlling interest, it is not surprising that the allocation process seems

to occur in a way that does not create new large shareholdings. Panel B reports that most

IPOs do not have a new block shareholder after the listing and the average percentage of

issued shares held by all new block shareholders is only 3.49%. This provides some

preliminary evidence that control retention is an important post-IPO consideration.

    Traditionally, IPO studies have often assumed that pre-IPO firms are similar in terms of

their ownership structure or that they are wholly owned by an entrepreneur. However,

Table 2 highlights pre-IPO ownership structures are actually quite diverse. The statistics in

Panel B show that some firms are indeed wholly owned by a single shareholder, but there

are also firms with no large shareholders, that is, they are widely held. The latter often

                                             12

originates from a cooperative structure, which is popular for firms in the agricultural sector.

On average, each IPO in our sample has more than one insider and more than one major

capitalist. The sample distribution in Panel C also shows that only about 16% of the sample

IPOs are wholly owned by either insiders or major capitalists, but more than 25% of them

have no controlling shareholder. Overall, such differences in pre-IPO ownership structure

highlight the importance of investigating the potential divergence of interests between

managers and shareholders even before going public.

3. PRE-IPO OWNERSHIP STRUCTURE AND PROPORTION OF SHARES OFFERED

    This section investigates whether control retention is an important consideration for

pre-IPO owners/managers when making the decision regarding the amount/proportion of

shares offered to the public. We argue that a public issue always dilutes the ownership of

all original owners in equal proportion, but only those with a controlling interest before the

IPO should be concerned about losing control. Thus, IPO firms with concentrated

ownership are likely to be more conservative with respect to the number of offered shares

than those that are relatively widely held and managed by professionals. However, this

proposed negative relation between pre-IPO ownership concentration and the extent of

shares offered to the public is unlikely to be monotonic. If an IPO firm is wholly owned or

has very high concentrated ownership, its owners/managers may still be able to offer a

large number of shares without losing control after listing.

    To test this argument, we measure the extent to which IPO shares are offered to the

public (labeled PUBLICSHARES) by dividing the number of shares that are fully

subscribed to by new investors by the total number of issued shares at the completion of the

IPO. Note that we do not rely on the number of offered shares stated in the prospectus since

                                              13

this figure can be changed at managerial discretion. Instead, we use the final number of

subscribed shares reported to the ASX, collected from the DatAnalysis database. The

justification for scaling offered shares by total post-listing issued shares, as opposed to the

original number of shares before the IPO, is that the former is less susceptible to outliers.

3.1. Proportion of Shares Offered to the Public across Different Ownership Structures

    The motive to retain control can be first shown in Table 3, which reports the mean,

median and standard deviation of the PUBLICSHARES variable across different pre-IPO

ownership structures. First, we split the sample into five groups based on their pre-IPO

managerial ownership level. The summary statistics are presented in Panel A and show that

the median of the latter variable is higher at the lowest and the highest ranges of pre-IPO

managerial ownership (i.e., 0% to 20% and 80% to 100%) than at the middle ranges (i.e.,

40% to 60% and 60% to 80%). Thus, IPO firms appear to offer the lowest proportion of

shares to the public when the original managers only have a tenuous hold on control that

can be lost by large public issue. In Panel A, we also compare the standard deviation in the

PUBLICSHARES variable across the five groups of IPOs. If the decision related to the

extent of IPO shares offered to the public is not related to control retention motives, we

should observe similar variation in the PUBLICSHARES variable across different pre-IPO

ownership structures. However, this is not the case as can be observed from Panel A.

Similar to the comparison of mean and median, the standard deviation of PUBLICSHARES

is the smallest when pre-IPO managerial ownership is between 60% and 80%. This

indicates that when managers are most conscious about the possibility of losing control

                                              14

after listing, they do not have as much flexibility with respect to making the capital raising

amount decision as when they have very high or very low pre-IPO ownership.5

    Table 3 also reports preliminary evidence that pre-IPO managers and major capitalists

may have different objectives when going public. As shown in Panel B, we find that the

mean and median of PUBLICSHARES are lower when a firm is controlled by a manager

than when it is controlled by a capitalist. The latter therefore appears to be more concerned

about exiting through the IPO than about control retention.

3.2. Multivariate Regression

    We next employ a multivariate regression to test the relationship between the

proportion of shares offered to the public and pre-IPO ownership structure. The

specification of the basic model is as follows:

     PUBLICSHARES =α + β1 INSIDER + β 2 INSIDER 2 + β 3 CAPDUMMY
                                                                                                        (1)
           + β 4 log PRESIZE + β 5 log AGE + β 6 DEBT + β 7 BTM + β 8TECH + ε

    In the above regression model, INSIDER is the pre-IPO percentage ownership of

managers and its quadratic term is used to test the existence of a non-monotonic relation.

As explained earlier, we do not include both INSIDER and a measure for the aggregate

shareholdings of major capitalists in the same regression due to their high correlation (the

sum of these two variables is often closed to one). Thus, to account for the potential

influence of major capitalists on the IPO decision making process, our regression models

combines the INSIDER variable with the dummy variable CAPDUMMY, which indicates

the presence of a capitalist who has at least partial controlling interest. This specification is

less susceptible to the aforementioned multicolinearity problem. In the same vein, we also

5
  In an unreported test, we find that the differences in mean, median and standard deviation across the five
IPO groups are all statistically significant.

                                                    15

run alternative regression where we control for a different dummy variable, VENDUMMY,

which indicates the presence of a venture capital fund.

    The regression also includes other pre-IPO firm characteristics that may influence the

capital raising amount decision. Most of these variables control for the capital requirements

of IPO firm. In particular, firms with larger market valuation are likely to be able to achieve

the same amount of capital raised with relatively fewer offered shares. Large firms are also

likely to have more internal capital, thereby reducing their external capital requirements. As

a result, we control for firm size using the natural logarithm of pre-IPO market

capitalization (labeled LogPRESIZE), calculated as the number of pre-IPO shares

multiplied by the offer price.6

    Another control variable is the natural logarithm of firm age (labeled LogAGE),

calculated for each IPO firm as the number of years from the time of its foundation to the

listing date. While younger firms may have relatively higher capital requirement, we expect

that their short history may not allow them to market to the public a larger proportion of

issued shares. Further, the owners of older firms may also wish to sell a lot of shares to

realize their long-term investments.

    Following Pagano, et al. (1998), who document that one of the motives of going public

is to reverse the accumulation of debt, we control for the extent of pre-IPO borrowings and

expect that as an IPO firm has more debt, the management is likely to raise more funds to

repay it. For each firm, we calculate ratio of interest bearing debt over the total assets

(labeled DEBT), using audited pre-IPO balance sheet figures reported in the prospectus.

6
  We do not use post-IPO market capitalization to avoid endogeneity. All else being equal, post-IPO firm size
is obviously larger for firms that issue relatively more shares.

                                                     16

However, this variable has a number of extreme outliers (see Table 1) so we winsorized it

at the two standard deviation level.

    We also control for the growth potential of each IPO firm relative to its size. As there

are no pre-IPO firm characteristics that can describe future expansion opportunities and

management forecast of earnings growth in the prospectus can be over-optimistic, we rely

instead on post-listing market valuation of the firm. Specifically, we use the first-day book-

to-market ratio, calculated as the post-issue (pro forma) book value of equity divided by

market capitalisation of equity as measured on the first day, following Jain and Kini (1994),

Pagano et al. (1998) and Pham et al. (2003). As this variable is also a measure of relative

value, its inclusion accounts for the possibility that the original owners may use ownership

retention (which equals to one minus the proportion of shares offered to the public) to

signal higher firm quality, as suggested by Leland and Pyle (1977). Finally, we include a

dummy variable for high-tech firms (labeled TECHDUMMY) in all regressions to ensure

that the results are not specific to the recent periods of high volume of “dot com” and bio-

tech IPOs in Australia.

    The results of the regressions are produced in Table 4. The regression estimates of

Model 1 show that, where the quadratic term is not included, INSIDER is significantly and

negatively related to PUBLICSHARES. However, the results from other regression models

show that consistent with the summary statistics reported in Table 3, this relation is not

monotonic. In particular, the coefficient of the quadratic term of INSIDER, when included

(in Models 2, 5 and 6), is always significantly positive. This indicates that the relation

between INSIDER and PUBLICSHARES is negative at a low pre-IPO managerial

ownership range and positive at a high pre-IPO managerial ownership range. Depending

upon the specification, the turning point occurs where pre-IPO managerial ownership is

                                             17

around 52% to 68%. The negative relation below the turning point implies that at low pre-

IPO ownership levels, managers are not constrained by a desire to retain control since it

may be impossible for them to do so anyway. By issuing large amounts of shares, they can

even dilute the ability of other existing large shareholders to discipline them. In contrast,

the positive relation above the turning point implies that the higher the pre-IPO ownership

of managers, the greater the proportion of shares they can offer to the public without

relinquishing control.

    Models 3 and 4 account for the presence of an influential capitalist by incorporating

CAPDUMMY and VENDUMMY, respectively, as an additional explanatory variable each

regression. The results in Table 4 show that the coefficients of INSIDER and INSIDER2

retain their significance. The coefficients of both dummies are significantly positive in their

respective model. This indicates that unlike insiders, capitalists do not manage the business

on a day to day basis and are perhaps less interested about consuming private benefits,

hence it may not be essential that they retain absolute control at the completion of the IPO.

In the cases of corporate spin-offs or firms with venture capital investments, the major

capitalists may actual view the IPO as an exiting mechanism. Since there are substantial

barriers to selling shares in the aftermarket (e.g. lack of liquidity, lockup provision, etc.),

the positive relation between PUBLICSHARES and CAPDUMMY (or VENDUMMY) is

consistent with the notion that non-managerial major capitalists have a strong intention of

realize as much of their pre-IPO investments as possible at the IPO stage.

    As for other control variables, the coefficient of firm size is negative and significant,

indicating that large firms raise fewer new shares proportionally to their existing shares

than small firms. As expected, this reflects that for a fixed dollar amount of required

funding, firms with larger implied market capitalization do not need to raise as many shares

                                              18

relatively. There is a positive and significant relation between firm age and the proportion

of shares being offered, suggesting that managers of older firms are more inclined to view

the IPO as a method of exiting from their investment, or that they can sell relatively more

shares because older firms are perhaps more well-known to the public. The coefficient of

the DEBT variable is also positive and significant, which is consistent with the Pagano et

al. (1998) result that retiring exiting debt is a main objective of going public. Finally, we

find that the coefficient TECHDUMMY is significantly negative, indicating that it is

perhaps difficult to sell high-tech firms in an IPO without a substantial commitment of the

original owners through higher retained ownership.

    In addition, we perform a number of additional robustness checks. Instead of using the

quadratic term of INSIDER to account for non-linearity, we use a piece-wise linear

regression model, where the breakpoint occurs at the 60% level of pre-IPO insider

ownership. Similar to the results of Table 4, the relation between PUBLICSHARES and

INSIDER is significantly negative where the latter variable is below the breakpoint and

significantly positive when it is above the breakpoint. Another robustness check

disentangles the dependent variable PUBLICSHARES, which incorporates both new

(primary) shares raised and existing (secondary) shares sold (and in some IPOs, new shares

raised are also used to finance selective buybacks of the original owners’ equity stakes

and/or acquisitions of their related businesses). To examine whether control considerations

also influence specifically the actual capital raising decision independent of the original

owners’ decision to sell existing shares, we replace PUBLICSHARES with the amount of

new capital raised as a proportion of post-listing pro-forma market capitalization as the

dependent variable. The results are again similar to those of Table 4. Pre-IPO managers are

                                             19

reluctant to raise a large proportion of new capital when their pre-IPO ownership implies

that control may be lost. For the sake of brevity, we do not report these robustness checks.

4. PRE-IPO OWNERSHIP STRUCTURE AND ALLOCATION OF IPO SHARES

    This section examines the influence of pre-IPO ownership structure on managerial

discretion regarding the distribution of post-IPO shareholdings. This is not a direct

examination of issuers/underwriters’ favoritism in the allocation process, as we do not have

detailed (confidential) subscription-level data. However, we are able to observe the

distribution of shareholdings that emerges immediately after the allotment of IPO shares

from pre-quotation disclosure statements lodged with the ASX. While this distribution is

undeniably determined by market forces and underwriters’ allocation practices, many

studies suggest that it is also subject to managerial discretion. According to Mello and

Parsons (1998), pre-IPO owners/managers would pursue certain strategies that lead to the

creation of the most desirable post-IPO shareholding distribution to them. More

specifically, Brennan and Franks (1997) argue that attracting and allocating shares to large

shareholders may potentially result in a loss of control after listing. In contrast, Stoughton

and Zechner (1997) view large shareholders as a monitor, who can improve firm value after

the IPO. Considering both of this argument, we suggest that pre-IPO ownership structure

should have an important influence, because when pre-IPO managers are not so concerned

about losing control (i.e., when they do not own a lot of shares before the IPO anyway),

they may be less reluctant to market to or allocate shares in favor of new large

shareholders.

    We measure the ownership concentration of new shareholders using two variables. The

first is the total fraction of post-listing shares held by all new block shareholders (labeled

                                             20

NEWBLOCK). Under ASX Listing Rules, any shareholding that crosses the 5% threshold

must be disclosed. In addition, IPO firms must report the 20 largest shareholders that

emerge immediately after the allotment of IPO shares. We collect post-IPO ownership data

from both disclosure methods (using the DatAnalysis database) and compare them with pre-

IPO ownership data to identify new block shareholders, defined as those who are not a

major capitalist before the IPO and own at least 5% of issued shares after the IPO. As this

variable is subject to truncated by the 5% cut-off point, we construct another measure of

ownership concentration of new shareholders, which is the total fraction of post-listing

shares held by all new shareholders in the twenty largest shareholder list (labeled

NEWTOP20), to improve the robustness of our results. The relation between pre-IPO

ownership and the emergence of new large shareholders after the IPO is investigated using

the following regression model:

        NEWBLOCK =α + β 1 INSIDER + β 2 CAPDUMMY + β 3 PUBLICSHARES
                                                                                                            (2)
              + β 4 log POSTSIZE + β 5 RISK + β 6UNDRANK + β 7TECH + ε

     This specification is also tested with NEWTOP20 as the alternative dependent variable.

Similar to Equation 1, we use INSIDER and CAPDUMMY to test for influence of pre-IPO

ownership structure on the dependent variable. Based upon our earlier argument, we expect

a negative relation between INSIDER and NEWBLOCK (or NEWTOP20). However, unlike

in Equation 1, we do not consider the quadratic term of INSIDER to capture the possibility

of this relation being non-monotonic because even at a very high pre-IPO insider ownership

level, there is still a possibility that the original owners/managers may not be able to retain

absolute control if they have to issue a lot of shares due to a large funding requirement.7 In

7
  Even when pre-IPO managers have a very high pre-IPO ownership and their funding requirements are
relatively small (i.e., they are likely to retain control after the IPO), there is no reason to expect that this
relation becomes positive. In such cases, there is no clear incentive to allocate shares to new large

                                                      21

addition to INSIDER, we use CAPDUMMY to capture any potential influence of a major

capitalist who has some relative control before the IPO on the allocation decision. In an

alternative specification, we replace CAPDUMMY with VENDUMMY, which indicates the

presence of a venture capitalist fund among the pre-IPO major capitalists.

    While the pre-IPO ownership measures account for the influence of the original

owners/managers on the formation of post-IPO shareholding distribution, the other control

variables are included to reflect the possibility that some IPOs may not be able to attract

new large shareholders. In particular, we control for the percentage of post-listing shares

offered to the public (PUBLICSHARES) because it is naturally difficult for large

shareholdings to be formed when only a small percentage of issued shares are offered to the

public (free-float shares). Large shareholders may also avoid firms in which pre-IPO

owners/managers still retain absolute control interests because in such situations, the value

of large outside shareholder monitoring is minimal.

    Equation 2 also includes the natural logarithm of post-listing market capitalization

(labeled LogPOSTSIZE), which is the closing price of the first day multiplied by the

number of issued shares, to control for size effect. Because of their budget constraints and

preference for diversification, new investors are likely to be reluctant to subscribe for large

shareholdings in a large IPO, and we a post-listing rather than a pre-IPO measure of size to

reflect this consideration. In the same vein, new investors are likely to avoid large exposure

to risky firms as this adversely impacts upon their overall level of diversification.

Therefore, we also control for the riskiness of each IPO, proxied by the standard deviation

of daily returns during the first year of listing (labeled RISK).

shareholders as their monitoring benefits are likely to be minimal due to the presence of large controlling
interests of pre-IPO managers anyway.

                                                    22

The next control variable is underwriter reputation (labeled UNDRANK), which reflects

the possibility that large and well-known underwriters (or offer managers) may be able to

attract more large institutional shareholders due to their relationships and the former’s

marketing power. There are two main accepted methods of measuring underwriter

reputation, (1) the Carter and Manaster’s (1990) ranking of underwriters based upon their

tombstone positions and (2) the market share based ranking. We use the second method as

tombstone announcements are not common in Australia.8 In particular, we aggregate the

gross proceeds (of all the IPOs in the sample) of individual underwriters and dividing them

into quintiles. A dummy variable is constructed and, for each IPO, is equal to one if the

lead underwriter is in the top quintile (the most prestigious), and zero otherwise. Finally,

similar to Equation 1, the dummy variable for high-tech firms (TECHDUMMY) is included

to ensure that our results are not driven by the recent waves of “dot com” and bio-tech IPOs

in Australia.

    The regression results are reported in Table 5. All models show that there is a

significant negative relation between NEWBLOCK (or NEWTOP20) and INSIDER. This is

consistent with our earlier expectation that pre-IPO managers are likely to allocate shares in

favor of small shareholders, as proposed by Brennan and Franks (1997), when control

retention consideration is still relevant, that is, when they have control before the IPO. As

pre-IPO managerial ownership decreases, control retention becomes less of an issue, and

the percentage of post-listing shares held by new large shareholders increases, possibly

reflecting their monitoring benefits as suggested by Stoughton and Zechner (1997). In

several unreported robustness checks, we also test the models reported in Table 5 across

8
 Megginson and Weiss (1991) show that the ranking variables produced from these two methods are highly
correlated anyway.

                                                 23

different ranges of pre-IPO managerial ownership. The results show that the negative

relation between INSIDER and NEWBLOCK (or NEWTOP20) becomes less (or not)

significant when pre-IPO managers own more than 60% of issued shares before the IPO.9

Thus, if the pre-IPO ownership of managers is such that they are likely to retain control

after listing, then they are indifferent about the allocation decision.

    We also consider the additional influence of major capitalist presence in Models 2, 3, 5,

and 6. Only the coefficient CAPDUMMY is significantly negative in the regression model

involving NEWTOP20. Similar to the results from Table 4, this indicates that major

capitalists are not as highly interested in retaining control as pre-IPO managers. Among the

other control variables, PUBLICSHARES is the most consistently significant. Its positive

and significant coefficients in all regression models offer further evidence that control

considerations matter to the shaping of post-IPO ownership structure. In particular, this

finding indicates that the formation of large shareholdings appears to be allowed (or even

encouraged) in IPOs where the proportion of shares offered to the public is too large for the

pre-IPO managers to be able retain control, or that large shareholders may avoid IPOs

where these managers still have absolute control.

     Overall, our findings thus far indicate that when the pre-IPO ownership of the original

owners/managers is such that they are conscious about losing control after listing, the IPO

firm tends to issue fewer shares and is less likely to have new large shareholders.

Therefore, dilution of control is an implicit but potentially significant cost of going public

and the extent to which this cost influences key IPO decisions (e.g., the proportion and

distribution of shares offered to the public) depends upon pre-IPO ownership structure.

9
  It should be noted that although the 60% level is determined arbitrarily, it is closed to the turning points
implied from the results of Table 4, which reflect the ownership level where pre-IPO managers are most
concerned about losing control

                                                     24

Next, we extend the same analysis to cover the explicit costs of the IPO process (such as

underpricing and promotion expenses) as well as the total wealth loss to the original

owners. We argue that pre-IPO ownership concentration is again an important determinant

as it reflects the incentive of the original owners/managers to control these costs.

5. PRE-IPO OWNERSHIP STRUCTURE AND EXPLICIT COSTS OF GOING PUBLIC

    To examine the relation between pre-IPO ownership structure and the explicit costs

incurred during the IPO process, we divide the latter into two components and investigate

them individually. The first is underpricing, which is the opportunity cost of not being able

to offer shares to the public at their fair value and avoid unnecessary dilution. The second

consists of out-of-pocket expenses related to the marketing and ensuring the success of the

issue. We then follow Habib and Ljungqvist (2001) to construct the wealth loss measure,

which reflects the total cost of going public, and investigate its relation to pre-IPO

ownership concentration.

5.1. Underpricing

    It has been well-documented in the IPO literature that underpricing is a substantial but

necessary cost of going public. However, according to Ljungqvist and Wilhelm (2003), the

failure to control underpricing could also be in fact a classic agency problem. To examine

whether pre-IPO ownership concentration influences the incentive to reduce underpricing,

we use market adjusted initial return as a measure of the extent to which an IPO firm

underprices its shares. This variable (labeled MAR) is calculated as the first day return (i.e.,

                                              25

the difference between the closing price and the offer price divided by the offer price), less

the corresponding daily return of All Ordinaries (Industrials) Index.10

     Table 6 reports the average of underpricing (among other measures of issuing costs)

across different pre-IPO ownership structures. The sample is divided into five groups

according to pre-IPO managerial ownership in Panel A and into three groups according to

the identity of the pre-IPO controlling shareholder in Panel B. We find no clear pattern

indicating a negative relation between underpricing and pre-IPO managerial ownership. In

fact, average underpricing appears to be higher in IPO firms with more concentrated pre-

IPO ownership structures.

     We investigate this further through a regression model, in which underpricing (MAR) is

explained by pre-IPO ownership structure. Overall, the basic regression specification is as

follows:

     MAR = α + β 1 INSIDER + β 2 CAPDUMMY + β 3 log PRESIZE + β 4 log AGE +
                                                                                                        (3)
                  + β 5 DEBT + β 6 BTM + β 7 RISK + β 8UNDRANK + β 9TECHDUMMY + ε

     Similar to Equations 1 and 2, the incentive of pre-IPO managers is measured by their

total pre-IPO ownership (INSIDER). To control for the presence (or concentration) of

potentially influential capitalists, we use CAPDUMMY, then replacing it with VENDUMMY

as an alternative measure. In addition to these pre-IPO ownership variables, we also

examine an alternative specification which incorporates the effect of secondary sales of

shares, as suggested by Ljungqvist and Wilhelm (2003). As explained earlier, EXECSALE

and CAPSALE are the number of pre-IPO shares sold directly by managers and major

capitalists, respectively, divided by the total number of pre-IPO shares. These measures of

10
   The descriptive statistics in Table 1 show that the underpricing variable is highly skewed. Therefore, we
also use a logarithmic transformation of MAR but obtain essentially the same results.

                                                    26

secondary sales capture pre-IPO owners’ commitment to the firm and whether some of the

issuing costs are realized by them immediately at the IPO stage.11

     We also control for other potential determinants of underpricing, including pre-IPO

firm size (LogPRESIZE), firm age (LogAGE), debt to asset ratio (DEBT), book-to-market

ratio (BTM), after listing return volatility (RISK) and underwriter ranking (UNDRANK).

These factors are all related to the level of uncertainty and information asymmetry

surrounding an IPO firm, which is well-recognized by the IPO literature to be the main

explanation of underpricing. We expect that larger and older firms are generally more well-

known, that firms with low post-listing volatility and high book-to-market ratio are

associated with less uncertainty, and that those with pre-IPO debt should be more

transparent due to existing banking relationships. All should therefore have lower

underpricing. Further, Carter and Manaster (1990) argue that underpricing can be reduced

by the reputation effect of a prestigious investment banker.

     The results of this regression are reported in Table 7. Models 1 to 3 show that there is

no significant relation between pre-IPO managerial shareholdings and underpricing.

Interestingly, there is a positive and significant relation between CAPDUMMY and MAR,

indicating that the presence of influential capitalists appears to create a pressure on the IPO

firm to underprice more aggressively. This perhaps reflects that capitalists may have a

stronger intention to use IPO as an exiting strategy than pre-IPO managers. We also find

that the coefficients of EXECSALE and CAPSALE are both negative and significant.

Consistent with Ljungqvist and Wilhelm (2003), this suggests that when managers and

capitalists dispose their existing shares as a secondary sale, and thus realizing the cost of

11
   Note that if pre-IPO owners do not sale shares directly in the IPO, they still bear indirectly but totally the
cost of going public. This is because to cover the costs, they have to raise more shares (leading to more
dilution of ownership) than dictated by the funding requirement.

                                                       27

underpricing immediately at the IPO stage, they have a considerably stronger incentive to

lower underpricing.

    Among the other control variables, SIZE, DEBT, and BTM all significantly influence

underpricing in their expected directions, confirming that underpricing is often a result of

asymmetric information and uncertainty. In contrast to Carter and Manaster (1990), we

obtain the rather puzzling result that underpricing and underwriter rank is positively related.

This result is actually similar to more recent evidence from Beatty and Welch (1996) for

US IPOs in the 1990s. However, Habib and Ljungqvist (2001) argue that this positive

relation is possibly a result of underwriter choice being endogenous and suggest a

correction for endogeneity using two-stage least squares regression, in which the first stage

is a Probit model of underwriter choice. We follow their method and find that the positive

relation between underwriter rank and underpricing is indeed caused by endogeneity. This

result is not reported for the sake of brevity.

5.2. Promotion Expenses

    We next consider the impact of pre-IPO ownership structure on the incentive to control

promotion expenses. In Australia, these expenses include underwriters’ (or offer

managers’) fees, brokerage fees, advisory fees, legal fees, discretionary advertising

expenses, listing fees and other due-diligence (e.g. prospectus printing, auditing, etc.) costs.

In this study, we calculate the total promotion expenses by converting all of the above

expenditures into dollar values and sum them together. We exclude listing fees and due-

diligence costs from this calculation. These components are determined by regulations

rather than managerial discretion, and because they are often fixed amounts, their inclusion

could lead to a bias against small firms. Following Habib and Ljungqvist (2001), we then

                                                  28