Insider directors a plus for the stock of young entrepreneurial firms, study finds
June 1, 2008
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Not only do insider directors thwart much of the underpricing endemic to initial public offerings, as a recent study in the Academy of Management Journal found; insiders also turn out to be a considerable plus for young companies' stock performance for as long as two years after these entrepreneurial firms go public, according to research that will be presented at the annual meeting of the Academy of Management in August.
In the post-Enron era, however, there has been a push for outsider-dominated boards; in fact, both the New York Stock Exchange and NASDAQ now mandate that all companies they list have a majority of directors who are independent outsiders.
Not surprisingly, then, the new study's findings lead its authors to express doubts about such rules, at least as they affect young entrepreneurial firms.
"If shareholders benefit from insider domination, such control may be viewed as positive, causing us to question current mandates regarding outside majorities," write the report's authors, Bruce Walters and Mark Kroll of Louisiana Tech University and Peter Wright of the University of Memphis.
The professors investigated the post-IPO stock performance of 524 young firms (all 10-years-old or less) that went public in 1996 and 1997. Over the course of 24 months following their IPO dates, firms in which the top management team constituted a supermajority of the board enjoyed stock returns considerably greater than companies in which the TMT constituted half or less of board members.
For example, the study's authors estimate that firms in which three fourths of the directors were from the TMT enjoyed a stock gain about double that of companies in which the TMT accounted for only one third of board members. The benefit of a TMT supermajority, the professors found, was especially pronounced during a time of sustained industry growth.
Every rule has an exception, and the study finds the advantage of TMT board membership to dissipate in cases where a company's industry was in the midst of rapid technological change. "The success of such executives in arriving at the IPO stage is noteworthy," the authors write. But, "when dynamism is high, the need may arise to augment or replace TMT members in order to avoid organizational simplicity. To that end, outsiders can provide myriad resources and play important roles."
The research complements a study in the April/May issue of the Academy of Management Journal that credited insider directors with thwarting much of the underpricing that occurs in initial public offerings -- the sale of IPO companies' stock by their investment banks at below-market prices. "It would appear that higher levels of insiders on the board would allow for greater vigilance in avoiding underpricing by the underwriter," the study concluded.
Commented a co-author of the AMJ study, Prof. Robert Hoskisson of Arizona State University, "The conventional wisdom about corporate governance nowadays is that insiders are the bad guys on boards of directors. But that appears not to be the case for companies going public. More than the other players in IPOs, it is the insiders who are most committed to the firm's performance over the long haul. They are out to protect their employment status by garnering as much capital for the young venture as they can, and so they make the case against underpricing in board deliberations and in so-called 'road shows,' at which parties to IPOs make their pitch to potential investors."
The study to be presented at the Academy's annual meeting, entitled "Insider Dominance, Enivironment, and Post-IPO Performance," will be among several thousand studies presented at the conference. Founded in 1936, the Academy of Management is the largest organization in the world devoted to management research and teaching. It has more than 18,000 members in 92 countries, including some 10,000 in the United States. This year's annual meeting will draw more than 8,000 scholars and practitioners to Anaheim, California, from August 10th to 13th for nearly 1,700 sessions on a host of subjects relating to corporate organization and investment, the workplace, technology development, and other management-related topics