easing IPO Performance through Revealing Innovation Potential, Outlining Future Plans: How Firms can Reduce the Negative Effect of Insider Sales
IPOs based in America raised $155 billion in 2021. This was a record year in terms of IPO valuations. According to VerityData , insiders also sold $35.5 billion worth of shares in companies that went public in the U.S. in 2021. Insider sales can be a negative indicator of quality and reduce the value of IPOs.
How Firms can Reduce the Negative Effect of Insider Sales
We focus in a new Journal of Marketing study on the role of innovation potenio as a credible signal that reduces adverse selection in IPO deals with insiders sales. Research has shown that IPO firm managers have a tendency to hide information about future innovations from prospectuses in order to keep competitors from knowing about their plans. Managers seek to preserve their competitive edge by removing information about future products and markets that they might be entering in 40% of IPOs.
However, our research shows that IPO valuation is positively affected by investors being informed about future innovation plans. This allows managers to reduce information asymmetry and provides background information that assists investors in better gauging the impact of insider sales. It ultimately raises the value of the IPO.
We document the indirect effect of insider shares on IPO valuation to establish that innovation potential is a reliable indicator of firm quality. It has been shown that insider shares sales have a negative impact on IPO performance. Our research shows that companies with greater innovation potential sell less insider shares. When these sales occur, the stock price penalty is lower.
Indirect and Direct Effects of Innovation Potential
Indirectly, innovation potential has an indirect impact on IPO first-day returns and also reduces the impact of insider sales upon IPO valuation. These relationships are tested using data from 370 IPOs in the consumer-packaged and pharmaceutical industries. Innovation potential is measured using patents and new product preannouncements. We also use generic references to future innovations in the IPO prospectus. Even if companies do not disclose details about new products, generic references to future innovation can be used as a reliable indicator of quality.
Certain innovation potential proxies are more effective than others at indicating the firm’s true quality. Insider sales have a greater impact when patents are used than preannouncements or generic references to future innovation. This suggests that insiders seem to place more value on technological innovation, which they may perceive as more tangible, than in corporate communications or strategic actions that focus more on market-based innovation. Preannouncements have the greatest impact on first-day IPO returns. This suggests that retail investors should focus on the innovation potential closest to commercialization.
Investors can use our results to help them understand how insider sales happen. On average, insiders will be less likely sell their holdings if there is a rich innovation pipeline. Insiders may sell because they need liquidity or because they believe the firm’s value will fall in the future. Investors may not be able to discern the motivations of insiders because of the significant information asymmetry at the time the IPO was conducted. Investors who believe the sale is due to the latter reason will likely pay a lower price. Our model shows that a decrease in insider sales of 0-1 percent reduces IPO first-day return by 0.95%.
The following are some tips for managers who want to make their company public:
- Preannouncements of new products may be the best indicator of innovation potential. The total effect of preannouncements upon IPO first-day return is greater than that of generic references to innovation and patents. Preannouncements are seen by investors as the best indicator that an IPO company will be competitive. The IPO value increases by $34.88million when a new product is announced. However, in the pharmaceutical industry, preannouncements can be more valuable because of the longer life cycles that are characteristic for products.
- Managers of IPO firms should not have a sufficiently developed product or feel uncomfortable promoting it. Generic references to future innovation can grab the attention both of underwriters as well as retail investors. The direct positive effect of generic references on IPO first day returns is greater than patents. Although product announcements are not as effective in increasing the value of an IPO company, communicating the general direction for future innovation is sufficient.
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Source:Zixia, Reo Song and Alina Sorescu. ” Innovation Potential, Insider Sales and IPO Performance : How Firms can Mitigate Negative Effects of Insider Selling,” Journal of Marketing.
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