Professor Sam GARG (PhD, Stanford University) is a tenured Associate Professor of Entrepreneurship at HKUST Business School. He is a pioneer and renowned scholar in the research area of board dynamics in privately-held ventures and newly public-listed firms. He coauthored this article with Dr Hanny KUSNADI (PhD, HKUST), to explain how to scale promising entrepreneurial firms into successful public-listed firms by managing the internal board dynamics and the capital market expectations at IPO. Dr Kusnadi’s research focuses on firm valuation, corporate governance, capital markets, and innovation; she has extensive work experience in Silicon Valley and Singapore.
Only the most promising and innovative of the entrepreneurial firms are able to do an initial public offering (IPO). For those who can, an IPO is a major transformative event that is unlike others. The crucial transition to becoming a public firm is paved with new challenges and dilemmas that can shape the trajectory of these entrepreneurial firms.
In this article, we shed light on two critical aspects that first surface in the firm’s life at IPO: formal board leadership structure and capital market valuation. Many private ventures do not have elaborate formal board structures, but as public companies they are required to comply with regulations related to their board of directors. Another key change at IPO is the exposure of firms to capital market influences and pressures. How firms address and react to these critical changes has considerable long-lasting impact on firm behaviors and key outcomes.
Importance of board leadership structure on key firm outcomes
The board is a very critical aspect of corporate governance in public firms, and so structuring the right board at the IPO is important. Firms and their bankers give much attention to refreshing their boards of directors, and even “window dress” by hiring prominent individuals leading up to the IPO. However, it turns out that firms pay limited attention to the board leadership structure. Our research with fellow academics Qiang LI and Jason SHAW shows that characteristics of the board leadership structure shapes many key outcomes.
By board leadership structure, we mean the chair of the entire board as well as the chairs of the three major committees – that is, audit, compensation, and nomination and governance. Prior to IPO, privately-owned entrepreneurial firms usually have informal boards with very limited leadership structures. In contrast, public firms are required by the regulators to formalize their boards. At IPO, then, firms formally identify and create the board leadership structure (that is, the formal hierarchy of the board): some outside directors are appointed to chair positions, while others remain as ordinary directors.
Formal hierarchical structures such as board leadership structures are consequences of—and are consequential for—social systems. Yet, it is also clear that not all leaders in a formal hierarchical structure are appointed to their positions based on normatively accepted criteria. History is replete with examples of formal hierarchies in corporations, governments, and society more broadly that are based on favoritism, nepotism, politicking, friendship, or simply error. Scholars, firms, and policymakers implicitly assume that the assignment of chair positions is either normatively appropriate or inconsequential for effective board functioning and board-level outcomes. We question this assumption in a series of studies that we have published and are currently working on.
We examined more than 400 technology IPOs in the US between 2004 (post-Sarbanes-Oxley Act) and 2016. We focus on the formalization of the board leadership structure during the IPO. When a director’s experience, qualifications and overall fitness according to normatively accepted criteria are high vis-à-vis fellow directors on the board, but not recognized by appointments to the newly public firm’s board leadership structure, the director is undervalued on the board. By extension, board undervaluation refers to the average director undervaluation on the board, and it represents the extent to which the overall board leadership structure cannot be explained by normatively accepted criteria.
Board undervaluation explains key outcomes
We find that board undervaluation has strong explanatory power for several key outcomes. First, we find that the higher the board undervaluation, the higher the turnover levels of these outside directors. More frequent board meetings exacerbate these turnover levels. In a talk that the first author gave to CEOs and directors at a breakfast seminar organized by the Financial Times, one participant acknowledged and summarized (albeit in a gender insensitive manner): “Yes, big boys want big toys.” Furthermore, CEOs are also more likely to exit due to the toxic and dysfunctional environment that board undervaluation can create on the board.
Second, board undervaluation has multifaceted implications for hiring of new directors, as well as firm performance. Directors seem to care very much about preserving their current relative standing and opportunities for future standing on the board through recruitment of new directors. In particular, we find that higher board undervaluation is associated with lower qualifications among new directors. This recruitment behavior, however, unexpectedly improves firm performance. This is because these directors are marginally acceptable and help to straighten the formal hierarchy on these newly public firm boards.
Higher board undervaluation is also highly dysfunctional for key board activities. First, board undervaluation hurts board effective monitoring. For example, it is related to upward earnings management (a form of accounting manipulation that makes the CEO look better), and we find a stronger effect of board undervaluation on such earnings management for repeat CEOs (they are likely to recognize and execute on the opportunity) and a weaker effect for female CEOs (they are less likely to risk exploiting this opportunity). Unexpectedly, founder CEOs and non-founder CEOs do not exhibit any differences in exploiting the opportunity to engage in upward earnings management. In other research that is underway, our analysis suggests that board undervaluation also ultimately reduces firm innovation.
Overall, while new ventures, their advisors and even regulators emphasize issues such as board independence and board duality at the time of IPO, much research shows that these factors have very limited influence. By contrast, we have found a new parsimonious way of assessing board dysfunction through the new concept of board undervaluation. It explains several key outcomes including director exits, director recruitment, CEO exit, firm performance, accounting manipulation, and innovation. Our research shows that board undervaluation has a lasting impact.
Firm overvaluation at IPO and future innovation trajectory
As entrepreneurial firms undergo crucial transition from private to public status, they also have to deal with the new capital market pressures of being a public firm. A firm’s market valuation (note: this is different from a board valuation that relates to internal board dynamics) in particular is an extremely critical component of an IPO, and high market valuations are often regarded as the pinnacle of a successful IPO.
There is so much media attention on this specific metric that the quest to seek higher and higher valuations at IPO has resulted in the increasing phenomenon of firms being substantially overvalued at IPO – one has to look at only the most recent US IPOs such as Uber, Zoom, and Impossible Foods, as well as Hong Kong IPOs such as Meituan Dianping, and BeiGene.
Innovation is an important value-creating activity for firms, and it is unclear how the innovation trajectory is affected after the IPO. When firms are exposed to intense capital market pressure after IPO, they face the constant battle of balancing investors’ long-term versus short-term expectations. Investors desire solid long-term growth, but without compromising short-term performance. For overvalued firms, these pressures and expectations are highly amplified. So, the core dilemma for firms is how to meet these short-term performance expectations of the market, while continue being perceived as an interesting company with sustained long-term growth prospects.
In our research, we investigate how firms actually do this by looking at more than 1,900 innovative entrepreneurial firms in the US that performed an IPO from 1983 to 2013, and identifying those that are substantially overvalued at IPO. Collectively, we find that overvalued firms at IPO adopt a complex but prudent innovative strategy post-IPO that attempts to balance both short-term performance imperative and long-term growth prospects driven by innovation.
We summarize some of our key findings. First, we find that firms that are overvalued at IPO produce higher quantity of innovation after becoming public, as compared to similar IPO firms that did not suffer from substantial market overvaluation during their IPOs. Contrary to recent media perception that alludes to going public as hurting innovation, our study shows that for firms that had a successful IPO, it does not mean that they become lazy and complacent with regards to innovation. Firms simply adjust their innovation strategies in response to capital market pressures. To show rapid and sustained long-term growth, overvalued firms at IPO generate more innovation internally, as measured through number of patents, as well as acquire external innovation through acquisitions of other companies or direct purchase of patents already developed by other firms. Acquiring ready-made technologies is a very attractive alternative to developing innovation in-house as they are not only faster to implement, therefore providing a much higher probability of profit realizations, but are also less prone to failure. Furthermore, overvalued firms are also in a much more advantageous position to exploit their overvalued stock in buying other companies, and such acquisitions of external technologies are easily communicated and accepted by shareholders as a signal for future growth. As a result, firms are able to cater for the market’s long-term expectations of growth and continue to maintain their innovative image.
Second, firms also respond to the short-term performance expectations of the market by engaging in more exploitative innovation after going public. By exploitative, we mean that firms are innovating in more mature and well-known technological areas, instead of exploring newer and more novel innovation. Being exploitative help firms to avoid unnecessary risks that might potentially jeopardize their short-term financial performance, which thus allow them to satisfy short-term performance targets.
If you are involved in the IPO process and would like to participate in the upcoming studies at HKUST, please email Professor Sam Garg directly: samgarg@ust.hk
Overall, capital market valuation of firms during an IPO has implications on an entrepreneurial firm’s innovation trajectory. In contrast to their somewhat disruptive/radical innovation strategy pre-IPO, overvalued ventures adopt a more prudent innovation strategy after the IPO to balance the long-term and short-term pressures. The combination of superior handling of internal board dynamics and external market pressures will enable entrepreneurial firms to scale up effectively and become sustainable innovative public-listed firms.