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     The Impact of Venture CapitalistVCsVenture Ccapitalists as
                       Additional Monitors

                   in the on the External Audit Function in
                        Initial Public Offerings Market




                                      Suzanne G. Morsfield
                                      University of Arizona
                                University of Michigan—Dearborn

                                      Christine E.L. Tan
                                     New York University
                          Baruch College—City University of New York


                                        William L. Felix, Jr.
                                        University of Arizona


                                        DecemberApril 2003

                         Please do not quote or distribute without permission


Please address all correspondence to:                                                              Formatted: Indent: First line: 0"
Suzanne G. Morsfield
University of Arizona
Department of Accounting
301 McClelland Hall
Tucson AZ 85719
USA
Email: Suzanne@eller.arizona.edu
Phone: (520) 904-3893
Fax: (520) 621-3742


        We are grateful to Masako Darrough, Bharat Sarath, Joseph Weintrop, Mike Willenborg
and to the seminar participants at the 2003 International Symposium on Auditing Research and
to workshop participants at the University of Arizona and CUNY—Baruch College for helpful



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comments. We would also like to thank an anonymous venture capital fund for detailed
institutional information and discussions. All remaining errors are our own responsibility.




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                                                Abstract


        This paper examines the roleinteraction of a little-studied, but significant stakeholder—
the venture capitalistventure capitalist (VC)— with the audit function in the initial public
offering (IPO) market. While the potential monitoring roles of the external auditors and
underwriters haves been studied in the IPO accounting literature, a relatively recent stream of
research has begun to provide insight regarding the impact of other potential
monitors/stakeholders on a firm’s reporting and accounting decisions—e.g., boards of directors,
actuaries, etc/quality of other potential monitors—e.g., boards of directors, actuaries, etc.
Existing fFinance and accounting research have both provided evidence consistent with the
theory notion that VCventure capitalists play a significantlyvalue-added reduce agency cost and
information asymmetry issues role in their investee firms. This paper contributes to all theise
streams of study by providing first time evidence that in an IPO context a VCventure capitalist is
perceived to provides monitoring value (in the form of lower first day underpricing) incremental
to that of the other monitors presentexternal auditor. Specifically, our evidence suggests that
VCs not only mitigate the demand for information from the external auditor, but that they also
weaken the demand for insurance from the external audit function. Finally, for the smallest of
the IPO deals in our sample, VCs appear to be the only monitors to provide incremental
informational value. These findings are robust to alternative variable specifications. To our
knowledge theise results has not been previously documented.                                         Formatted: Font color: Black




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4
1. Introduction

        This paper examines how the monitoring role of a little studied stakeholder—the venture

capitalist (VC, hereafter)—is valued by investors in an initial public offering (IPO) setting. The

business media and finance literature generally characterize VCs as extremely active

shareholders who add value through their superior screening, monitoring, and contracting skills

and incentives. Despite the general perception of the relative importance of VCs in a firm’s

business structure and decisions, this economically significant stakeholder has remained little

studied in the accounting literature to date.1 Because VCs play an integral role in the IPO

process and are involved with one in three IPOs, we attempt to answer the following questions:

Are VCs perceived to contribute information and/or monitoring to the IPO market in addition to

that already provided by auditors and underwriters?

        The public market for new issues appears to treat auditors as both a source of information

and a source of insurance against future potential losses in firm value (Dye, 1993; Willenborg,

1999). On the other hand, VCs are suggested to add value by reducing information asymmetries

and agency conflicts due to their additional (or superior) screening, contracting, and monitoring

skills (Kaplan and Strömberg, 2000a and 2000b). While an extensive body of research has

focused on identifying and measuring the role of external auditors in public firms, we believe the

study of VCs allows us to contribute to a relatively recent stream of study which has begun to

examine the potential value-added roles of other stakeholders/monitors in the same firms.                     is

1
 To our knowledge the only accounting research that has directly included VC presence are Engel, Gordon, and
Hayes (2002) and Morsfield and Tan (2003). Engel et al. (2002) find that VCs significantly impact compensation
contract design in entrepreneurial firms. Morsfield and Tan (2003) show that VC presence in an IPO is significantly
associated with lower income-increasing discretionary accruals, fewer income-decreasing restatements, and
improved long-run returns.




                                                                                                                   5
         To address our research question we provide an empirical model which attempts to

separately examine the added value (as measured by lower first day underpricing) of the key

stakeholder/monitors present in an IPO. We also utilize Willenborg’s (1999) research setting,

that for the first time in the audit literature, empirically separates and measures the informational

versus insurance roles of external auditors in small deal IPOs. This setting is one means for

testing how the IPO market values the role(s) of VCs. We initially directly reproduce his test

period and research design except to also capture the presence of a VC.2 We expect and find that

VCs are perceived to provide significant monitoring and informational value in this setting.

         We then explore the monitoring role of VCs in further detail.3 As a result of these

additional tests we are able to present new evidence that the impact of and potential demand for

both the informational and insurance aspects of external audits appears to be significantly

attenuated in the presence of a VC in certain IPO contexts. Perhaps most importantly, for the

smallest of the IPO deals in our sample, VCs appear to be the only source of incremental

informational value.

         Finally, we examine the impact of varianceheterogeneity in VC-specific traits in an IPO                          Formatted: Normal, Indent: First line: 0.5"


setting. The extant academic literature has not always emphasized VC heterogeneity, implicitly

treating VCs as a homogenous group so that VC reputation differences and monitoring abilities

are obscured among VCs (Hsu 2003). In particular, we modelexamine how the ’sVC’s

investment stake, age, IPO experience, and participation on the board of directors (ie., proxies

for VC quality) are associated with IPO underpricing. We expect and find that higher VC
2
  We initially seek to reproduce the research setting in Willenborg (1999) as closely as possible. We realize that this
limits the time frame and also makes the research period relatively old. However, we believe that building on
existing evidence is critical to most powerfully testing the impact (or not) of the VC on the external audit function.
3
  Our extensions and modifications rely on the theoretical audit models of Titman and Trueman (1986), and of Datar,
Feltham, and Hughes (1991). We find the Datar, Feltham and Hughes(1991) model particularly salient since in our
opinion it captures or allows for more of the institutional realities consistent with VC investment and involvement in
IPO firms.



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quality is associated with lower underpricing to contribute to the informational quality and flow

incremental to that provided by the underwriter and the external auditor. We contribute to the

accounting research stream that is examining and documenting value-added roles of

monitors/stakeholders in addition to the external auditor. We also contribute to the existing audit

demand literature by demonstrating a setting where the insurance and informational roles of the

external audit function are significantly supplemented or replaced by another informational

intermediary—i.e., the VC.                                                                               Formatted: Font: Bold


       The paper continues as follows. Section 2 describes the existing VC and audit literature          Formatted: Body Text Indent, No
                                                                                                         widow/orphan control

and model in more detail.    Section 3 details the sample and research method. The results are

presented and discussed in Section 4. Section 5 concludes the paper with a summary and some

suggestions for future research.



2. Literature review and model development                                                               Formatted: Font: Bold
                                                                                                         Formatted: Body Text Indent, Numbered +
       Despite the existing evidence regarding the relative importance of VCs in a firm’s                Level: 1 + Numbering Style: 1, 2, 3, … + Start
                                                                                                         at: 1 + Alignment: Left + Aligned at: 0" + Tab
                                                                                                         after: 0.25" + Indent at: 0.25"
business structure and decisions, this stakeholder/monitor has remained little studied in the

accounting literature to date. In particular, VCs play an integral role in the IPO process and are

involved with one in three IPOs (Sahlman, 1990; Morsfield and Tan, 2003). We extend

Willenborg (1999) to include the presence of a venture capitalistVC when examining the demand

for audits in an initial public offering (for relatively small deals). We expect and find that

venture capitalistVCs do provide monitoring value incremental to that of the auditor. We also

present new evidence that the impact of and potential demand for the external audit function in

an IPO setting appears to be attenuated in the presence of a venture capitalistVC.                       Formatted: Font: Bold




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While the role of the external auditor has been studied in the accounting literature, a relatively       Formatted: Tab stops: Not at 1.11"


recent stream of research has begun to provide insight regarding the impact of other key

monitors—e.g., actuaries in constraining the insurance industry earnings management (Gaver

and Paterson, 2001); boards of directors and audit committee members in generally constraining

earnings management (Klein, 2002); venture capitalistVCs in performance measure design

(Engel, et al,Gordon and Hayes, 2002); underwriters in micro-cap IPO long-run performance

(Weber and Willenborg, 2003); and venture capitalistVCs in constraining IPO-related earnings

management (Morsfield and Tan, 2003). All of these studies generally illustrate that in addition

to the auditor, other monitors or “expert informational intermediaries” (Weber and Willenborg,

2003, p.1) appear to play significant value-relevant monitoring roles. This study contributes to

this stream of research by documenting for the first time that in an IPO context a venture

capitalistVC provides monitoring value incremental to that of the external auditor.

Empirical audit research generally supports the theory elucidated by Dye (1993) that external            Formatted: Body Text Indent


audits may fulfill both an informational role and an insurance role in publicly-traded companies.

Until recently, the informational role of the audit function is generally documented by providing

evidence that auditor quality varies as per Titman and Trueman (1986). This variance leads to

qualitative differences in the information provided by the audit, which in turn, leads to

quantitative differences in both the relevant firms’ audit fees and their subsequent return

underpricing effects.4

New research by Weber and Willenborg (2003) attempts to more directly address the question of

the informational value of the audit report to investors. They examine small, non-venture backed

IPOs where auditors are likely to be the only source of independent information. They

document a predictive relation between larger (i.e., higher quality) auditors’ pre-IPO going
4
    For example, see Balvers, et al (1988), Beatty (1989), DeAngelo (1981).


                                                                                                     8
concern opinions and first-year stock returns. They also find that larger auditors are more likely

to issue going concern opinions for distressed firms.

The insurance role of audits had been documented via the positive relation between IPO auditor

size/auditor compensation and the amount of IPO underpricing (Menon and Williams, 1994;

Baber, Kumar, and Verghese, 1995). Willenborg (1999) found that underpricing is decreasing in

auditor quality. He also noted that the observed underpricing in start up companies seems to be

driven primarily by the insurance, not informational role of the chosen auditor. Since

Willenborg (1999) is the first paper to attempt to separate these competing roles of the external

audit, we directly build upon his approach and sample period in the current study. 5

We extend Willenborg’s (1999) analysis of the demand for auditing in IPOs to include venture

capitalistVC impact. We include this additional stakeholder/monitor because finance theory, and

accounting and finance empirical evidence suggest that VCs play an important role in their

investee firms.6 In particular, VCs should significantly mitigate informational asymmetries

(Kaplan and Stroömberg, 2001). Recent evidence also suggests that in an IPO setting where VC

presence is related to constrained earnings management, subsequent long-run underperformance

is also mitigated (Morsfield and Tan, 2003).

Because of their unique monitoring abilities and incentives, venture capitalistVCs may often

oversee their portfolio firms to such a pronounced degree (especially in the early years of a firm)

that they are involved in virtually all aspects of a portfolio firms’ management. This activism

ranges from more standard board membership to less standard micro-level operational decisions.



5
  We are seeking to reproduce the research setting in Willenborg (1999) as closely as possible. We realize that this
limits the time frame and also makes the research period relatively old. However, we believe that building on
existing evidence is critical to most powerfully testing the impact (or not) of the venture capitalistVC on the external
audit function.
6
  For example, Barry, Mascarella, Peavy, and Vetsuypens (1990); Sahlman (1990); Brav and Gompers (1997);
Kaplan and Stroömberg (2001); Engel, Gordon, and Hayes (2002); and Hellman and Puri (2002).


                                                                                                                      9
Such close proximity to the firms’ day-to-day operations (including financial reporting

decisions) by a significant and often powerful investor may reduce the pre-IPO information

asymmetry. That is, it may be suggested that VCs provide additional monitoring in such a way

and to such an extent as to act as a significant substitute and/or complement to the external

auditor’s informational role (Sahlman, 1990; Black and Gilson, 1998).

VC’s incentives and actions also are also motivated by include reputation-building/ and/or

maintenanceance, and litigation avoidance. Success in the VC world is measured by not only the

ability to consistently make and sustain the largest returns on their investments, but by the ability

to attract limited partners who contribute the cash to be invested by the VC fund. Limited

partners are more likely to fund and re-fund those VC firms that have a reputation of successful

IPOs—as defined by sustained long-run return performance —since this success maximizes the

return on the limited partners’ initial cash investment. Given these additional incentives, it is

reasonable to expect venture capitalistVC presence to absorb some of the insurance role of the

external auditors as well.

In the current study we utilize a sample of venture capitalistVC-backed IPOs from 1993-1994

(consistent with Willenborg, 1999). We build on and adapt Willenborg’s (1999) models of

auditor choice and related IPO underpricing. He separates the competing roles of external

auditors by examining a specific IPO context—i.e., the development-stage enterprise (DSE) IPO.

He suggests that by focusing on DSE IPOs he has “isolate[d] a setting (i.e., start-ups with

virtually no revenues or audit-intensive assets) where audit quality is less important and the risk

of company survival ((hence, the insurance-based demand for auditing) is more important (p.

226).”




                                                                                                    10
We initially adapt Willenborg (1999) to include an indicator variable for the presence of a

venture capitalistVC in the IPO. We find that the reported auditor insurance role documented by

Willenborg (1999) is significantly diffused in the presence of a venture capitalistVC. We further

find that the venture capitalistVC presence is related to significantly reduced underpricing in the

same sample of firms. This finding is consistent with both an incremental informational and

insurance signalling role of the venture capitalistVC in this context.

WSince the we would also like to examine in more detail the impact of VCs on the informational

role of auditors in IPOs,. To do this, weWe further extend Willenborg (1999) by changing the

setting from DSE IPOs to VC-backed IPOs. Since VCs play a dual role of principal and agent

(Kaplan and Strömberg, 2001), Wwe make this change to be able to examine further the impact

of the VC on the monitoring and flow of information in the current IPO setting. This extension

is also an attempt to control the information environment from a perspective different from

Willenborg (1999) to assess if our findings are robust to differing definitions of the information

environment.

VC-backed IPO firms are likely to have significantly reduced information asymmetry issues due

to the active financial reporting monitoring and governance role played by the venture

capitalistVC described earlier. Consistent with a relatively more significant informational role

for VCs Wwe expect and find that for VC-backed IPOs, the audit function has no impact on

underpricing. However, for the largest, non-VC-backed IPOs in our sample (where

informational asymmetries are likely to be more pronounced), we find the expected result that

the choice of a non-national (lower quality) auditor is related to higher under-pricing.

Our findings contribute to both the accounting and finance literatures. We contribute to the

extant finance VC literature by showing again for the first time that the presence of a venture




                                                                                                  11
capitalistVC in an IPO is related to less underpricing. We contribute to the accounting research

stream that is examining and documenting value-added roles of monitors in addition to the

external auditor. We also contribute to the existing audit demand literature by demonstrating a

setting where the insurance and informational roles of the external audit function are

significantly supplemented or replaced by another external informational intermediary—i.e., the

venture capitalistVC.

The paper continues as follows. Section 2 describes the existing VC and audit literature and

model in more detail.   Section 3 details the sample and research method. The results are

presented and discussed in Section 4. Section 5 concludes the paper with a summary and some

suggestions for future research.



Literature Review and Model DevelopmenThe agency literature specific to the audit function

as a source of monitoring consistently predicts that auditors add value by providing a costly

information signal (i.e., communication) to the market regarding the entrepreneur’s true type.

However, the models vary significantly as to their respective underlying assumptions about the

information content of the various types of communication listed above. By extension, the

models also vary with respect to some key aspects of what one might conclude about the actual

information content and context of the audit.

       Titman and Trueman’s (TT) (1986) seminal model of the informational role of the audit

in new public equity issues predicts that the auditor choice alone provides the signalling

equilibrium among different quality IPO firms. They assume that the auditor provides new pay-

off information to both the investors and to the owner/entrepreneur, and that the stake the owner

retains in the company is exogenous and thereby provides no additional information. Also a




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result of these assumptions, they further conclude that auditor quality choice by the entrepreneur

is an increasing function of entrepreneur type, and a decreasing function of entrepreneurial firm’s

riskiness.

       Alternatively, Datar, Feltham, and Hughes (DFH) (1991) assume that auditors provide an

independent examination/report of the entrepreneur’s proposed financial communication to only

the potential investor—i.e., the key difference from TT (1986) is that this auditor report is

assumed to contain no new information for the entrepreneur. The role of the auditor choice and

audit report is to signal information only to the potential investor. Finally, they also assume

(contrary to TT, 1986) that the percent of the entrepreneur’s retained ownership conveys

additional private information and that the entrepreneur can and will vary this percent as needed

to communicate to the investor her type.

       As a result of their assumptions, DFH (1999) find that the audit report and the percent

retained ownership jointly signal the entrepreneur’s private information—the percent ownership

amount is chosen to eliminate any remaining uncertainty about the firm’s type not resolved by

the auditor report. The predictions further indicate that the auditor choice communication

provides some, but not all the private information, and that the combination of the auditor report

and the retained ownership is the key to obtaining a separating equilibrium. Finally, in the DFH

(1991) setting, auditor quality choice is therefore predicted to be increasing in firm risk.

       Relatedly, Dye (1993) presents a model of audit pricing in the presence of auditor

litigation risk and asymmetric information in the market about the entrepreneur firm’s true

expected value. In this setting, tThe external auditor may be viewed as a source of both

information and insurance to investors in an initial public offering setting (Dye, 1993). The

informational component is defined as the audit’s role in the relative improvement of resource




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allocation decisions in the market place. The liability component reflects the value of the option

that the auditor is essentially selling to the investor that entitles the investor to a claim against the

auditor’s assets in the event of an audit failure (i.e., the audit does not signal a future failed firm

correctly).

        While prior audit research has examined in some detail the role of the auditor or audit

report in reducing informational asymmetries in the market, little research has examined the

insurance role of auditor choice on a firm’s expected value. Although Dye’s (1993) model

focuses on the price of audits, a possible link to the finance theory with respect to the insurance

aspect of underpricing is worth pursuing. If auditors’ prices include a premium for the

insurance they provide to investors, is there lower insurance-related underpricing for firms that

engage auditors that can provide this type of insurance to their investors?

        Until Willenborg (1999), audit research had not separately examined the potential

informationalese differing (Datar, et al, 1991) and insurance (Dye, 1993) roles of the external

audit function. He identifies a sample of development stage enterprises (DSEs), per SFAS No. 7

(DSEs) and non-DSE IPO firms to control for the information role, while allowing the insurance

role to vary. Willenborg (1999) argues that DSE IPO firms are usually start-ups with little or no

revenue, and with little or no serious audit issues (i.e., therefore with significantly reduced

information asymmetry concerns). In this sense, he further suggests that the DSE IPO setting is

one in which the informational (insurance) role of the external auditor is significantly less (more)

important than in a more mature IPO firm.

        Willenborg (1999) measures the information and insurance roles primarily by regressing

first day underpricing (argued to be a proxy for both information asymmetry and expected future

financial loss risk) on auditor quality and other control variables (including underwriter quality).




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When examining the relation between auditor quality and first day underpricing for the DSE-

only IPO firms, he argues that the informational role of the auditor is controlled for, and that the

audit function’s perceived insurance role is the only remaining observable role for the auditor.

This expectation leads to the notion that it the market perceives auditor quality providing a type

of insurance to investors against future losses, then investors will price-protect themselves less in

the presence of a high quality auditor. This notion in turn leads to the testable prediction that for

DSE IPOs underpricing is inversely related to auditor quality. Willenborg (1999) documents this

predicted association as evidence consistent with the insurance role of auditors in IPOs.



        IPO Underpricing

        Underpricing is simply the word commonly used to describe the often the soften

substantial price run-ups that areis observed on the first day trading day for an IPO firm.

Economically, the existence of these run-ups suggests an incorrect offer price (i.e., that the

entrepreneur has underpriced her own firm relative to how the investor values the firm) and

therefore has “left money on the table” in the process of raising external capital. Finance

textbooks note that this money left on the table is often one of the largest components of a firm’s

cost of raising equity capital—averaging between 10%-20% over the past several decades

(Brealey and Myers, 1991; Ross, Westerfield, and Jordan, 1996). Despite the steady presence of          Formatted: Font: Not Bold


underpricing, researchers have yet to fully explain the phenomenon or to even reach a consensus

on the existing possible explanations of IPO underpricing—informational, insurance, and/or

control. 5




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                  Informational Role                                                                                         Formatted: Font: Bold
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         The underpricing puzzle can be categorized into theories based on asymmetric

information or symmetric information (Ritter and Welch, 2002).6 Theories of underpricing

based on asymmetric information in general suggest that the underpricing is positively related to

the degree of asymmetric information (see Ritter, and Welch (2002) for a more detailed literature

survey).7 The presence of unresolved informational asymmetries is the most widely-agreed upon                                Formatted: Font: Not Bold


explanation for underpricing among academics. In short, this explanation suggests that investors

on average undervalue the firm at the IPO due to their remaining uncertainties about the firm’s

true type. As the asymmetric information uncertainty approaches zero, then underpricing

disappears entirely (Ritter and Welch, 2002). Theoretical and empirical findings document the

entrepreneur’s attempts to provide additional signals/communication to the market to overcome

this problem (e.g., employing better quality auditors and underwriters). Recent accounting

research has specifically documented that increased pre-IPO disclosure is related to lower

underpricing (Schrand and Verrecchia, 2003).

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                  Insurance Role                                                                                             Formatted: Font: Bold
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5 Since we are focused in this study on examining the incremental impact of the VC relative to the auditor, we rely
on the information and insurance role explanations of underpricing which are consistent with the prior auditor
theoretical and empirical models. These two roles are especially consistent with the Willenborg (1999) empirical
model upon which our study is based.
6
  Note that Ritter and Welch (2002) argue that since simple market misvaluation or asset-pricing risk premia are
unlikely to explain the average first-day return, the solutions to the underpricing puzzle lie in the setting of the offer
price, where the normal interplay of supply and demand is suppressed by the underwriter.
7
  It is important to note that the finance literature does not yet suggest a single model of the determinants of
underpricing, so our (Willenborg’s) model is subject to the criticism that it may not be the best model of
underpricing available. Again, since our study is intended to build directly on the findings of Willenborg (1999), we
believe it important to base our test design on the underpricing model he chose. In general, we observe goodness of
fits ranging from 3%-28% in the finance literature. Our 2.5%-17.5% goodness of fit findings are compatible with
the existing research.



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         The other category of theories for underpricing is based on symmetric information (Ritter

and Welch, 2002). The studies examining this explanation tend to focus on the issuers’

incentives to underprice in order to reduce their legal liability exposure (e.g., Hughes and Thakor

(1992) and Lowry and Shu (2002)). For instance, if the price of the stock in the aftermarket

drops below the offering price, then the likelihood of being sued increases. Issuers can avoid this

by lowering their offering price in order to reduce this likelihood of the post-issue price dropping

below the offer price.

         Schwartz and Menon (1985) and Menon and Williams (1994), amongst others, suggest

that audits provide investors a form of insurance. If an investor purchases securities based on the

information contained in the prospectus and subsequently suffers losses, and if some form of

audit failure can be demonstrated, the investor has recourse against the auditor. Hence, the

auditor can be viewed as providing financial statement users with a form of insurance. In

particular, larger audit firms are perceived to have “deep pockets” since they can potentially

provide a larger coverage in the event of litigation.

         It is likely that the auditor choice in an IPO provides a signal of the insurance coverage

to IPO investors. This is consistent with Dye’s (1993) model of audit pricing in the presence of

auditor litigation risk and asymmetric information in the market. The insurance role of audits

had been documented via the positive relation between IPO auditor size/auditor compensation

and the amount of IPO underpricing (Menon and Williams, 1994; Baber, Kumar, and Verghese,

1995).




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       The Roles of Venture Capitalists

       We introduce VCs into the existing frameworks of audit demand because of the

additional monitoring and information asymmetry-reduction roles that they may be expected to

play in an IPO framework. The role of the VC in providing value-added monitoring to firms in

which they invest has been examined in some detail in the finance literature. As noted earlier,

VCs are investors/stakeholders noted to mitigate principal-agent conflicts by three main means:

(1) extensive pre-investment screening; (2) post-investment monitoring and advising; (3)

sophisticated financial contracting (Kaplan and Strömberg, 2001).

       The inclusion of VCs in a test of the demand for auditors is also consistent with DFH’s

(1991) model of audit demand. Since DFH (1991) assume that the auditor choice alone does not

resolve all information asymmetry concerns, the entrepreneur may utilize other choices to further

communicate the expected value of her firm. In the DFH model, the other choice is the percent

retained ownership (conditioned on the audit report and the auditor choice). DFH (1991) also

note in their conclusion that their model allows for other interpretations, such as the inclusion of

underwriters as an alternative information-asymmetry reducing mechanism. By extension, the

entrepreneur may provide other costly signals of quality such as the quality of underwriter

chosen, or the decision to first raise capital on the private market through an entity known for its

extensive screening, monitoring, and contracting skills—e.g., the VC.

       Finance empirical research provides extensive evidence that the VCs do behave toward

their investee firms in the ways predicted by agency theory (for example, see Barry, et al, 1990;

Kaplan and Strömberg, 2000; Lerner, 1995; Hellman and Puri, 2000; Hellman and Puri, 2002).

These studies confirm expectationsdemonstrate that VCs are actively involved in their investee

firms. In a detailed examination of VC contracts and memorandums, Kaplan and Strömberg




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(2000) find that a majority of VCs explicitly state their expectations that they will be involved in

monitoring existing management through such activities as: membership on the board of

directors, business plan development, structuring of mergers and acquisitions deals, assisting

with networking, and even in designing employee compensation agreements.

       A relatively large body of finance literature has detailed the information gathering and          Formatted: Indent: First line: 0.5"


disseminating roles and incentives of a venture capital fund in entrepreneurial and IPO firms.

Recent empirical accounting research has also confirmed a significant role in specific

accounting and reporting decisions—e.g., compensation plan design (Engle, Gordon, and Hayes,

2002) and IPO earnings management mitigation (Morsfield and Tan, 2003). The reasonable, yet

to date unstudied, extension of the existing VC findings is that the VC’s presence may therefore

serve to either complement or even substitute for certain aspects of the external audit function in

an IPO.

          In the Willenborg (1999) model of audit demand we expect and find evidence consistent

with the notion that VCs add informational value to the market incremental to that of the external

auditor in the form of less underpricing.   However, we make no predictions with respect to the

VC’s impact on the insurance role of underpricing since there is little, if any theoretical models

from which to develop clear expectations.

       We introduce venture capitalistVCs into Willenborg’s (1999) framework of audit demand

because of the additional monitoring and, information asymmetry-reductionn, and litigation

avoidance roles that they may be expected to play in an IPO framework. We examine VCs and

auditors (controlling for investment banker quality) in this setting since thesey are the two key

IPO monitors noted as relevant in existing theoretical, empirical, and anecdotal evidence.

Kaplan and Strömberg (2001) suggest that the presence of venture capitalistVCs in a firm’s




                                                                                                    19
investment and governance structure serves to reduce principal-agent conflicts. However, they

note that empirical research has done little to examine the parallels, or lack thereof, between real

world principals in the market and their counterparts in finance theory. They further state that

“… in our view, VC’s are real world entities that closely approximate the [principals] of

[agency] theory (pg. 1).” VCs are noteworthy due to their perceived opportunities to actually

implement theoretical, conflict- reducing behaviors arising from extensive investee contracting,

information collecting, monitoring, and support capabilities (Kaplan and Strömberg, 2001).

       Venture capitalistVCs become actively involved in the management and governance of

the firms that they fund (Sahlman, 1990; Barry et al., 1990). Empirical and anecdotal evidence

suggest that venture capitalistVCs monitor, find new management, and also advise existing

management (Kaplan and Strömberg, 2001). For instance, they typically become board

members, help recruit and determine compensatione ofrfor key individuals, work with suppliers

and customers, help establish tactics and strategies, play major roles in raising capital, and help

structure transactions such as mergers and acquisitions (Sahlman, 1990; Lerner, 1995; Hellman

and Puri, 2002). More importantly, venture capitalistVCs are often more experienced than

management in bringing a firm public because they have had more practice in the IPO process

(Lerner, 1994).

       The reputation of the venture capitalistVC is also critical to its continued existence and

success in the venture capital industry. Limited partners receive periodic updates on the

performance of the venture capitalistVC’s investment activities and since they do not participate

in policy decisions, evaluation of the venture capitalistVC’s ability is difficult (Gompers, 1996).

Hence, investors continually seek for signals of ability when evaluating venture capitalistVCs in

which to invest or re-invest.




                                                                                                    20
          One key signal documented in the VC research and in the VC industry literature is tThe

relative success and ease with whichability of, and success to which, a venture capitalistVC can

bring a firm public. is considered a signal of the quality of the venture capitalist and

thereforeIPO success increases the capital a VCit can raise in subsequent follow-on partnerships

(Gompers, 1996). Gompers also notes in particular that older and more established venture

capital firms with long track records of successful IPOs can raise funds more quickly and with

less effort from their own investment partners. Successful IPOs (defined as IPOs that earn at

least the required return by the VC fund), convey that the VC general management team can

identify, monitor, and manage investment opportunities which consistently earn an appropriate

return.

          Since VC fund investors reassess their priors regardingon the venture capitalistVC

investment capability after the IPO, the venture capitalistVC has added incentives not to be

associated with IPO failures (Brav and Gompers, 1997). In addition, since venture capitalistVCs

repeatedly bring firms public, their reputations and ability to raise additional venture funds in the

future may be tarnished if they have been associated with IPOs that have soured (Brav and

Gompers, 1997).

          A relatively large body of finance literature has detailexplained the information gathering

and disseminating roles and incentives of a venture capital fund in entrepreneurial and IPO firms.

Recent empirical accounting research has also confirmed a significant role in a specific

accounting and reporting decisionss—e.g., compensation plan design (Engle, Gordon, and

Hayes, 2002) and IPO earnings management mitigation (Morsfield and Tan, 2003). The

reasonable, yet to date unstudied, extension of the existing VC findings is that the venture




                                                                                                  21
capitalistVC’s presence may therefore serve to either complement or even substitute for certain

aspects of the external audit function in an IPO.

In the Willenborg (1999) model of audit demand we expect and find evidence consistent with the

notion that VCs add value to the IPO firm incremental to that of the external auditor in the form

of less underpricing. Due to the extent of the VC’s reputation-buildinglitigation avoidance

incentives and their access to and dissemination of otherwise private manager information as

described earlier, we also expect and find the respective insurance and informational roles of

external audit function to be significantly limited in a venture-backed IPO.



                                                                                                                         Formatted: Font: Bold




3.3. Methodology and Data                                                                                                Formatted: Bullets and Numbering


         We identify U.S. domestic IPOs for the period January 1993 through December 1994

from the Security Data Corporation Venture ExXpert database. To be consistent with

Willenborg (1999), the sample is limited to IPOs that raise $10 million or less. This results in a

final sample of 261 IPO firms.

         Since Willenborg (1999) is the first empirical model to attempt to separate the insurance

and information signalling roles of the auditor, our model initially builds directly on the IPO

underpricing regression and research design in Willenborg (1999). This particular version of an

underpricing model and research design is constructed specifically to examine whether the

presence of a VC mitigates the insurance and/or information signalling roles of the auditor.8


8
 Although many other underpricing models exist in the extant literature, only the Willenborg (1999) version and
research design attempts to utilize the underpricing phenomenon to disentangle the information versus insurance
roles of IPO monitors. Since this is not an underpricing study, we focus on reconciling our results to the findings of
Willenborg (1999). Relatedly, this is not a study which attempts to explain VC investment choices (i.e., our study


                                                                                                                   22
Consistent with Willenborg (1999), we thus disentangle the information role from the insurance

role of auditors by specifying the auditor intercept variables that depend on the size of the IPO in

an underpricing regression estimated for the DSE and non-DSE sub-samples. As the deal size

increases, the amount of potential litigation risk rises and hence the failure to select a large

auditor with deep pockets is associated with greater underpricing. The following regression is

estimated:




Ln(Underpricing ) i   0   1VBIPO   2 %RETAINED   3 LOWIBi   4UNITi
                                    i               i
                                                                                                                   (1)
                          5 1 / PRICEi   6 LOWSM i   7 LOWLGi   i
where:



Ln(Underpricing)           = LN(1 + market-adjusted first-day initial return);

VBIPO                      = 1 if the IPO is backed by a VC, and zero otherwise;

%Retained                  = percentage ownership retained by pre-IPO shareholders;

LowIB                      = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0, and zero

                           otherwise:




is ex post the investment decision and the client acceptance decision, similar to Willenborg (1999)). Rather, our
focus is limited to the important task documenting the respective roles of different monitors with differing incentives
when they are jointly present in an IPO setting. Hence, our study directly builds on the most recent research design
that attempts to actually separate and measure the various theoretical roles (i.e., insurance and informational) of such
monitors. Importantly, unlike the existing audit research we also are thus able to examine how these roles may also
change in the presence of additional key players in the IPO process.



                                                                                                                    23
where Carter, Dark, and Singh ranking is an update of the Carter and Manaster (1990) proxy for          Formatted: Normal, Indent: Left: 0",
                                                                                                        Hanging: 1.5", Line spacing: Double, Tab
                                                                                                        stops: 1.5", Left
                        underwriter reputation based on the position of the firm’s name in IPO

                        “Tombstone” announcements in the business press. This proxy ranges

                        from 0.0 to 9.0 and the 6.0 cutoff for low reputation is from Schultz

                        (1993);

Unit                    = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise);

1/Price                 = reciprocal of the IPO offer price per share or per unit;

LOWSME(Non-national)              = for OLS equals 1 if a non-national auditor (LOW) and has

                        relatively small (SM) gross proceeds (less than or equal to $6 million

                        (sample median), and zero otherwise; for 2SLS equals 1 if a non-national

                        auditor is associated with the IPO and this association is predicted with a

                        probablility greater than 0.5 by the first-stage probit; and

UE(Non-national)LOWLG             = for OLS equals 1 if a non-national auditor (LOW) and has

                        relatively large (LG) gross proceeds (greater than $6 million (sample

                        median), and zero otherwise.

; for 2SLS equals 1 if a non-national auditor is associated with the IPO but this association is not

                        predicted with a probability greater than 0.5 by the first-stage probit.



          The dependent variable is logarithmically transformed to mitigate distributional problems     Formatted: Normal, Indent: First line: 0.5",
                                                                                                        Line spacing: Double

(see Willenborg, 1999) and is also market- adjusted by subtracting the return on the respective

exchange on which that the firm is seeking to be listed to be listed on. Our variable of interest is

VBIPO and its coefficient captures the association between the presence of the VC and

underpricing in the presence of other control variables. The remaining control variables are




                                                                                                   24
drawn from Willenborg (1999) and are commonly-cited explanatory variables in underpricing

models.

        Both LOWSM and LOWLG indicate the percentage association with underpricing of                      Formatted: Normal, Indent: First line: 0.5",
                                                                                                           Line spacing: Double

choosing a non-national auditor for a relatively smaller and larger deal, respectively. These

variables are consistent with Willenborg’s (1999) external audit test variables. By adding a deal

size (ie., proceeds) measure to the standard auditor quality dummy , Willenborg (1999) suggests

that we are able to also test the litigation exposure risk (i.e., the insurance role) of the chosen

external audit firm. This explanation is supported by the observation that for most IPO-related

audit failure lawsuits the cash settlements are limited to the total dollar value of the deal

proceeds.

        In general, if VC presence is a substitute for the perceived demand for auditors by the

market, then the VBIPO variable is expected to have a significant negative sign and the

LOWSM/LOWLG measures are expected to be insignificantly related to underpricing.

If VCs are perceived to be a complement to auditors we predict a significant negative sign on

VBIPO and significant negative signs on the auditor measures (where Willenborg (1999) found

such an association). If VCs provide no incremental value to the firm, we expect no association

with underpricing and no significant change in the relation between auditor and underpricing

found by Willenborg (1999).




          In addition, since the auditor choice decision precedes the IPO decision and the                 Formatted: Tab stops: Not at 1"


observed relation between auditor type and underpricing, we also re-estimate regression Model




                                                                                                      25
(1) to take into account the sequential nature of the auditor choice/going-public decision. Again,

similar to Willenborg (1999), we therefore estimate the following:



       1 if Non-national                                                                                      Formatted: Indent: First line: 0.5", Line
                                                                                                              spacing: Double

       0 if Big 6/ Second Tier Auditor

                                                                                                              Formatted: Font: Not Bold
                                                                                                              Formatted: Font: Not Bold
         0  1 PROCEEDSi   2 RISKFi   3 S1i   4 LN ( Assets) i   5 LEVi   6 FSubsi   i   (2)

                                                                                                              Formatted: Indent: First line: 0.5"


       where:

       Proceeds        = IPO gross proceeds;                                                                  Formatted: Indent: First line: 0.5", Line
                                                                                                              spacing: Double




       #RiskFactors = number of risk factors listed in the IPO prospectus;



       S-1             = 1 if issuer files an S-1 registration, and 0 otherwise;



       Ln(Assets)      = Ln(pre-IPO total assets);



       Leverage        = long-term debt divided by total assets (pre-IPO); and



       FSubs           = 1 if issuer has foreign subsidiaries, and 0 otherwise.




                                                                                                        26
               In the two-stage least squares regression version of regression Model (1), we

determine the probability of selecting a nonnational auditor using the estimated parameters from

the auditor choice regression (regression Model (2)). The variable E(Nonnational)

(UE(Nonnational)) equals one if both a nonnational auditor is associated with the IPO and if this

association is (is not) predicted with a probability greater than 0.5 by regression regression

Model (2). The variable UE(Nonnational) equals one if a nonnational auditor is associated with

the IPO and if this association is not predicted with a probability greater than 0.5 by regression

Model (2). Willenborg (1999) suggests that it is important to attempt to model the sequential

nature of the auditor choice decision. Both OLS and 2SLS results are presented in Table 3,

Panel B.


4.4. Results                                                                                              Formatted: Bullets and Numbering


           Descriptive Statistics

       Table 1, Panel A provides the descriptive statistics for IPOs that are venture and non-

venture-backed, respectively. VC-backed IPOs employ more prestigious underwriters

(t=-2.041), are less likely to involve unit IPOs (t=-1.860), raise more proceeds (t=1.979), and are

less likely to employ low quality (non-national auditors) when the gross proceeds are less than or

equal to $6 million (t=3.043). They are also less likely to employ low quality (non-national)

auditors when proceeds are greater than $6 million (t=1.864). In summary, with respect to the

various levels of quality of the various monitors/stakeholders in IPOs, VC-backed IPO firms

appear to attract higher quality auditors and underwriters than non-VC-backed IPO firms. This

observation is consistent with anecdotal, business media, and research evidence that indicates

that market participants in general, and other key IPO players may perceive VC presence as




                                                                                                     27
source of additional, valuable information gathering, pre-screening, contracting, and monitoring

skills.

          Table 1, Panel B provides the descriptive statistics for IPOs that are DSEs and non-DSEs.

Development stage enterprises have a lower percentage of ownership retained by the pre-IPO

investors (t=-2.726), are more likely to be unit IPOs (t=1.975), and are larger proceeds deals

(t=1.765). In addition, DSE firms appear to appoint fewer low quality (non-national) auditors in

smaller deals (t=-2.205), and to appoint more low quality (non-national) auditors in the larger

deals (t=3.060).

          Table 2 provides Pearson and Spearman correlation data. The presence of the VC is not

significantly correlated with an IPO firm being a DSE but is significantly negatively correlated

with low underwriter reputation and unit IPO., VC presence is alsoand positively correlated with

the IPO gross proceeds. These correlations suggest that VC-backed IPO firms are more likely to

be associated with underwriters with better reputations, unit IPOs, and relatively larger issues in

the small deals market. DSE IPO firms are more likely to be the relatively larger issues in the

small deals market, unit IPOs, and riskier firms.




          VC and Auditor Impact on Underpricing

Controlling for the Auditor Choice Process                                                             Formatted: Indent: Left: 0", First line: 0"


Since the auditor choice decision precedes the IPO decision and since prior research supports          Formatted: Indent: First line: 0"


the relation between auditor type and underpricing, we estimate the bivariate probit auditor



                                                                                                  28
choice regression to instrument the E(Non-national) and UE(Non-national) variables for the

underpricing regression based on the DSE and non-DSE samples. Table 3, Panel A tabulates

these results.(SUE – should the first paragraph on pg. 15 be here instead??)

Similar to Willenborg (1999), virtually all control variables are not statistically significant except

for Proceeds (in the Non-DSE sub-sample). An exception is S-1(in the DSE sub-sample). This

control variable is significantly negative in our DSE sub-sample, but was not significant in

Willenborg’s (1999) sample. This small difference may be attributedable to slight differences in

sample construction. Firstly, note that we have 41 (220) observations in our DSE (non-DSE)

sample compared to 57 (213) observations in Willenborg (1999). Secondly, Willenborg’s (1999)

sample of domestic U.S. IPOs is constructed from “Going Public: The IPO Reporter,” whereas

our sample is determinedattained from the Securities Data Corporation VentureExpert

Database.

                                                                                                                     Formatted: Heading 3, Indent: First line: 0",
                                                                                                                     Line spacing: single

                    Control for the Information Environment—DSE versus Non-DSE IPOs                                  Formatted: Indent: First line: 0.5"


           Table 3 , Panel B presents the OLS results for the underpricing regression, partitioned on

DSE versus non-DSE IPOs as in Willenborg (1999).9 We expect that the presence of the VC in

an IPO to be generally associated with lower underpricing because the presence of a VC: (1)

reduces the information asymmetry by providing an additional layer of monitoring, and (2) acts

as an information signaling, since the fact that the VC plays a dual role of investor and manager

is perceived by the market to reduce agency costs (Kaplan and Strömberg, 2001)???Chris we

need to add something in here, any thoughts?. The indicator variable, VBIPO, which equals one                        Formatted: Font: Italic


if the IPO is backed by a VC, and zero, otherwise, is significantly negative in the non-DSE


9
    We reproduce Willenborg’s (1999) exact model specifications on our sample of firms with similar findings.



                                                                                                                29
sample for both the OLS (t = -2.432) and is 2SLS (t = -2.490) regressions, and not significant in

the DSE sample.

       The non-DSE finding (i.e., that VC presence reduces underpricing in these IPO firms) is

consistent with expectations that in an environment of relatively more informational uncertainty,

VCs will provide valuable informational signalling and information asymmetry reduction as

indicated by lower underpricing. Also noteworthy is that this impact is observed even in the

presence of the external auditor. Finally, we observe that the introduction of the VC into the

model results in a loss of significance on the auditor quality/deal size coefficient as compared to

Willenborg’s (1999) results. Willenborg’s t-statistic = 3.25 sfor LOWLGUE(Nonnational)                 Formatted: Font: Italic


(arewithout VC presence). In the presence of a VC (in our sample) the t-statistic = 1.796 for

LOWLG. While not a powerful test of differences in coefficients across regression models, the

fact that the auditor variable (as defined in Willenborg’s study) loses significance in our study in

the presence of the VC is consistent with the notion that the VC may substitute for certain

aspects of the external audit function in some IPO contexts—i.e., in the non-DSE, relatively

larger of the small deals sub-sample of firms.   and 0.114 (0.25) for the OLS and 2SLS models,

respectively.

       The DSE finding (i.e., that VC presence is not related to underpricing) is consistent with

expectations. This finding is expected because the DSE sub-sample by definition is thought to

have relatively lower informational asymmetry issues, such that any observed impact on

underpricing is predicted to be a measure of the perceived insurance provided by the external

monitors or stakeholders. Because VCs are expected to primarily add value through their skill at

reducing information asymmetry, we are not surprised that their presence is not correlated with

underpricing.




                                                                                                  30
         However, in contrast to Willenborg (1999) we find that when VC presence is introduced

into the DSE model, the LOWLG auditor variable in our sample becomes completely

insignificant (t = 2.84 in Willenborg; t = 0.419 in our sample). Again, while not a strong test of

differences in coefficients across regressions, this result is at least consistent with the notion that

although VCs do not impact DSE underpricing directly, they appear to indirectly attenuate the

market’s demand for insurance from the external auditor. This finding would be supportive of

the generally held idea in the business media and in the VC industry, that VC presence in an IPO

is often viewed by the investment community as a signal of reduced information asymmetry and

lower associated riskiness of future returns for VC-backed IPO firms. That is, VCs may serve

as a substitute for some of this need for insurance otherwise fully imputed to external auditors.

To our knowledge this result has not been previously documented.

         With the exception of 1/Price, the results for the remaining control variable in the

underpricing regression are consistent with that of Willenborg (1999). The percentage of

ownership retained by pre-IPO shareholders, % Retained, is positively significant (t = 2.712) in

the non-DSE sample and not significant in the DSE samplefor the OLS and 2SLS regression and

t=2.735, respectively. Both underwriter ranking (LOWIB) and unit IPO status (UNIT) are not

significantly associated with IPO underpricing across either the DSE and non- DSE samples.10

          As an additional check, we directly compare the economic significance of the difference

in the VBIPO coefficient between the DSE and non-DSE sub-samples. We re-estimate the

underpricing regression for the whole sample and include an indicator variable that is equal to

10
   Willenborg (1999) notes that except for the positive sign on %Retained, his (and therefore, our) findings are
consistent with the existing underpricing literature. He explains that the %Retained finding is likely an artifact of
his (and by extension, our) sample design which has many low or no reputation underwriters. In contrast with
Willenborg (1999) the 1/Price control variable is not significant in our non-DSE sample (Willenborg sample
t = 3.36; our sample t = 1.457). To the extent that VC presence may have a direct or indirect impact on first day
opening offer price (is is therefore a correlated omitted variable) it is possible that introducing VBIPO absorbs some
of the 1/Price significance. This relationship is not the focus of the current study, so we do not perform further tests.



                                                                                                                     31
one if the firm is a DSE, and zero otherwise; an indicator variable that is equal to one if the firm

is backed by a VC, and zero otherwise; and an interaction variable that captures the joint

presence of a DSE and VC (DSE_VBIPO). The regression is as follows:



Ln(Underpricing )i   0  1DSE   2VBIPO   3 DSEi _ VBIPO   4 %RETAINED
                                           i                  i               i
                                                                                                    (2)
                       5 LOWIBi   6UNITi   71 / PRICEi  8 LOWSMi   9 LOWLGi   i

           The coefficient on the interactive variable, DSE_VBIPO, captures the incremental

association between the presence of a VC in a DSE and IPO underpricing. Although this

variable is positive, it is not statistically significant (results not tabulated). This would suggest

that the VBIPO coefficient is not statistically different between the DSE and non-DSE sub-

samples.



                New Control for Information Environment—VC versus Non-VC IPOs                                Formatted: Indent: Left: 0.5"


        Theoretical, empirical, and anecdotal evidence consistently predict that VC presence

serves to reduce the information asymmetries in an IPO setting. Hence, we introduce a new

control for the information environment in Table 4—i.e., we separately examine the VC-backed

and non-VC-backed IPOs. By partitioning the sample in this manner, we are attemptingable to

separate the sample into a low information asymmetry context (VC-backed) versus a relatively

high information asymmetry context (non-VC-backed). We then focus on the impact of the

external audit function in these contexts by examining the coefficients on LOWSM

E(Nonnational) and LOWLUE(NonnationalG).                                                                     Formatted: Font: Not Italic


        Table 4 Panel A presents the first-stage auditor choice regression for the whole sample.

The results in the probit regression are qualitatively similar to the results presented in Table 3,




                                                                                                        32
Panel A for the non-DSE sample. This is possibly due to the overwhelming presence of non-

DSEs (versus DSEs) in the current IPO sample.

          Table 4, Panel B presents the OLS results of the underpricing regression for the sample

partitioned on VC presence. When a non-national (lower quality) auditor audits a small IPO

with proceeds less than or equal to $6 million (LOWSME(Nonnational)), there is no significant

association with underpricing regardless of VC presence. This is consistent with Willenborg

(1999).

          The coefficients for LOWLGUE(Non-national) for the non-VC-backed sample in the                            Formatted: Font: Italic


OLS and 2SLS regressions isare significant at ten percentthe 10% level of significance and

positive (t=1.809 and t=2.028, respectively), and reflects the percentage impact on underpricing

of selecting a non-national (lower quality) auditor for an IPO deal with gross proceeds raised

between $6 million and $10 million. In this setting where relatively higher audit quality may

assist uninformed investors to overcome problems of exacerbated information asymmetry (since

the IPO is not backed by a VC), the result is consistent with an information- signalling role of the

auditor. However, this relation between under-pricing and auditor type emerges only for the

relatively larger end of the small deal market, and thus is also consistent with an insurance role.

          Finally, in contrast to Willenborg (1999) we observe that for the sub-set of firms in our

sample that are VC-backed, the coefficient on LOWLG UE(Nonnational) becomes insignificant

(Willenborg t = 2.84 for DSEs, t = 3.25 for non-DSEs; our t = 1.307). This result is consistent

with the idea that VC presence mitigates both the informational and insurance roles of the

external auditor in this sample of firms.11 To our knowledge this observation has not been




11
  This finding may also suggest that Willenborg’s results were driven primarily by the non-VC-backed IPO firms in
his sample.


                                                                                                              33
documented in the prior audit literature and suggests that auditor impact documented in prior

studies may be driven primarily by the non-VC-backed firms in the sample.12




        New Control for the Insurance Environment—Impact of Deal Size

        Willenborg (1999) is the first study to attempt to separate out the differingcompeting

auditor roles—i.e., information versus insurance. However, he primarily attempted to control the

informational environment (via DSE vs. non-DSE firms), so as to separately observe the impact

of and demand for the insurance role of the external auditor. We extended those tests as reported

earlier by adding a control for the presence of a VC. In this section we follow a similar

approach in an attempt to then control the insurance environment, so as to separately observe the

impact of and demand for the informational role of the both the VC and the auditor (while

controlling for underwriter presence and quality as well).

        Table 5 presents results when we partition the sample on deal size (which serves as a

proxy for the insurance role of the audit function). Small deal IPOs are suggested to provide a

context where the insurance role of auditors is less significant, since deal proceeds are relatively

small. Instead, the more dominant role of the auditor in a small deal IPO setting role may

actually be to provide information that is not as readily available to the market as that in large

deal IPOs. However, we document that for these smallest deals (in relatively small deal IPOs)

the audit function does not have a significant impact on underpricing (t=-1.072-0.718). Yet,

wWhen we introduce the VC into the regression, we find a significantly negative impact on

12
  To examine the potential role of endogeneity in our findings, we perform Hausman tests and we reproduce
Willenborg’s (1999) 2-stage least squares models for all relevant regression models (not reported). We find no
evidence of endogeneity in our results.




                                                                                                                 34
association between VC presence and underpricing (t=-2.975). Assuming that this setting

controls for the insurance demanded by the IPO market, this finding is consistent with the idea

that any value-added monitoring or mitigation of information asymmetry is in fact perceived to

be provided primarily by VCs (in the smallest of the small IPO deals).

       Table 5 also documents the roles of auditors and VCs in the relatively larger deal sizes

end of our IPO sampleIPO setting. In this setting, it is suggested that both the informational and

insurance roles are likely relevant, with the insurance role potentially dominating, sincebecause

more information is available to the market for larger deal IPO firms. In this context we find that

low quality auditor is positively correlated with underpricing (t=2.0077). We find no impact for

the VC in this sub-sample.

       In summary, Table 5hese results in summary suggest that VC informational impact is

most relevantpronounced in relatively small deal IPOs, where they appear to be a clear substitute

for the external audit function. Conversely, in the relatively larger deals, it is only the external

audit function which appears to provide value as measured by lower underpricing. Taken

together these results suggest a potentially significant conclusion that the respective significance

of the roles of key stakeholders or monitors (when jointly present) may vary between serving as

substitutes or complements for each other as the details of the context itself vary. In this case,

the respective roles of the VC and auditor vary with IPO deal size (less than or equal to $6M vs.

greater than $6M) and by type of IPO firm (DSE vs. non-DSE). Hence, it appears important

when studying the joint significance of several monitors or stakeholders to be aware of this

phenomenon that the nature of their relationship to each other and to the dependent variable may

in fact be more fluid than static.




                                                                                                       35
Auditor Compensation

                DSE versus non-DSE IPOs                                                                    Formatted: Indent: Left: 0.5"


         Table 6 extends Willenborg’s (1999) tests of the relation between auditor compensation,

and audit effort proxies and an auditor insurance proxy. Willenborg’s regression model is as

follows:



Ln( AuditFee)   0  1VBIPO  2 Ln( Assets)   3 Invrec   4 s1   5 Sqsubs   6 FSub
                                                                                               (33)
                  7 Opinion   8 Big6   9 Ln(Pr oceeds)  




where:

Ln(AuditFee)           = Ln(Auditor compensation for IPO engagement);

VBIPO                  = 1 if the IPO is backed by a VC, and zero otherwise;

Invrec                 = (Inventory + Trade receivables)/Total assets;

Ss1                    = 1 if issuer files an S-1 registration, and 0 otherwise;

Sqsubs                 = square root of the number of subsidiaries;

Fsubs                  = 1 if issuer has foreign subsidiaries, and 0 otherwise;

Opinion                = 1 if a going-concern audit opinion, and 0 otherwise;

Big6                   = 1 if a Big Six auditor (high quality), and 0 otherwise; and

Ln(Proceeds)           = Ln(IPO gross proceeds).


         He found auditor compensation to be primarily driven by deal proceeds, which serves as

an upward bound on potential litigation settlement amounts, and which thereby proxies for the

insurance premium priced into auditor compensation. He again partitions the sample between



                                                                                                      36
DSE and non-DSE firms to further control for the information environment. He finds that the

insurance proxy is significantly positive in both sub-samples.

       When we introduce VC presence into thise model we find no significant insurance role

for auditors in the DSE sample (in contrast to Willenborg—t = 2.87 for Ln(Proceeds); our

sample—t = 1.693). As noted earlier, although the significance of the coefficients are not tested

across the different regressions, the fact that the variable becomes completely insignificant in the

presence of our variable of interest—VBIPO—is worth noting. Relatedly, the VC variable is

also insignificant in our sample of firms.

       Since VCs are not typically a potential defendant in “market fraud” litigation, the fact

that their presence appears to attenuate the insurance role of auditors is not explained by the

notion that VCs become the litigation target instead. Rather, VC presence in the IPO firm’s

corporate governance structure appears to mitigate the auditor’s need to price protect themselves

against potential litigation for perhaps other untested reasons such as additional confidence in the

firm’s management/reporting quality, or additional confidence in the DSE IPO firm’s corporate

governance structure (due to the presence of VCs and their perceived skill set and influence over

management, and potentially over the financial reporting).

       Finally, for the non-DSE sub-sample the significantly positive relation between deal            Formatted: Indent: First line: 0.5"


proceeds and auditor compensation is consistent with the findings of Willenborg (1999). This

finding supports the idea that for the more complex audit settings (as represented by the non-

DSE firms), auditors will price protect themselves against future litigation, regardless of VC

influence or presence.




                                                                                                  37
               VC-backed versus non-VC-backed IPOs                                                       Formatted: Indent: Left: 0.5"


       We extend Willenborg (1999) again in this section by partitioning the sample into VC-

IPOs and non-VC-IPOs to further identify the impact of VC presence on the insurance role of the

external auditor (as proxied by auditor compensation). We find (results not presented) as before

that when VC presence is identified, there is no observable auditor insurance role (as proxied by

Proceeds), except in the non-VC-backed IPO firms. This result suggests that Willenborg’s

(1999) findings regarding auditor compensation are possibly primarily driven by the non-VC

portion of his sample.




               Venture Capital Characteristics and Underpricing                                          Formatted: Font: Bold
                                                                                                         Formatted: Indent: Left: 0.5", First line: 0.5"
       The impact of venture capitalist heterogeneity on information asymmetry reduction has             Formatted: Indent: First line: 0.5"


not been examined in the literature (Hsu 2003). In particular, when the quality of the firm cannot

be directly observable in an IPO, external investors rely on the quality of the firm’s affiliates as a

signal of the firm’s own quality (e.g., underwriter or auditor reputation). We turn our focus to

examine proxies for VC reputation and monitoring abilities which might explain the variation in

underpricing of IPO firms in the small deal market.

       We examine the following proxies for VC reputation and monitoring abilities: VC

representation on the board of directors of the IPO firm, VC pre-IPO investment in the firm, VC

age and VC experience in bringing firms to public. Consistent with existing theories of control,

we expect the VC to provide more monitoring as the VC’s equity stake in the firm increases

(Kaplan and Strömberg 2003). Specifically, as the VC’s stake in the IPO firm increases (i.e., as

a proportion of the total known amount invested in the firm pre-IPO), we expect the VC to be




                                                                                                   38
more vigilant in reducing information asymmetry and thus reducing IPO underpricing.

Similarly, we expect the VC to be able to provide additional monitoring as the VC increases its

representation on the board of the investee firm.

       VC age is one proxy for VC reputation. Since unsuccessful VC firms are unlikely to

survive in the long-term, older VC firms are perceived by investors to be more established and to

be of higher quality (Gompers and Lerner 2002, pg. 46). In addition, as VCs become more

experienced in bringing firms to public (the most visible and profitable exit strategy for the VC),

their reputation is updated and refined by investors.

       For the entire sample of firms in this study, we estimate the underpricing regression and

replace VBIPO with the various proxies for VC reputation and monitoring abilities:



Ln(Underpricing )i   0  1DSE   2VCCHARi  3 DSEi _ VCCHARi   4 %RETAINEDi
                                                                                                (4)
                     5 LOWIBi   6UNITi   71/ PRICEi  8 LOWSMi  9 LOWLGi   i

                                                                                                       Formatted: Indent: First line: 0.5"


where VCCHARi is one of the following: VC board representation (the number of board seats

held by the VC); VC pre-IPO investment (the amount of pre-IPO VC investment as a proportion

of the total proceeds of the IPO); VC age (the time period from the inception of the VC firm to

date of the IPO); and VC IPO experience (the number of other IPOs that the VC firm has been

involved with prior to the current IPO). The results are presented in Table 7.

       The results suggest that when we replace VBIPO with various proxies for VC reputation

and monitoring abilities (i.e., VC quality), we find that underpricing varies in the expected

direction according to variations in VC quality for non-DSE firms (i.e.,  2 ). With the exception     Formatted: Lowered by 5 pt


of VC experience with IPOs, greater VC quality (as proxied by VC representation on the board,




                                                                                                  39
VC Age, or VC pre-IPO investment) is associated with lower underpricing. The interactive

variable between DSE and VC representation on the board is significantly positive. This

suggests that the incremental association between VC representation on the board and

underpricing is greater for DSE firms than non-DSE firms. Overall, when we replace VC

presence with proxies for VC quality, our results are consistent with our previous findings that

the significance of auditor quality for the relatively larger deals is significantly attenuated.



        5.5. Conclusion and Future Research                                                             Formatted: Bullets and Numbering


        In summary, we perform multiple tests that consistently support the previously

undocumented prediction that in a small deal IPO VCs provide information value incremental to

that provided by the external audit function. We also provide first time evidence that the

insurance role of the auditor in the same setting is actually attenuated in the presence of a venture

capitalistVC. Finally, for the smallest of the IPO deals in our sample, VCs are the only monitors

that appear to provide incremental value. Taken together these results suggest a potentially

significant conclusion that the respective significance of the roles of key stakeholders or

monitors (when jointly present) may vary between serving as substitutes or complements for

each other as the details of the context itself vary.

        This study makes significant contributions to both the finance and accounting literatures.

We contribute to the finance literature by quantifying the value-added impact of VC presence—

i.e., by documenting lower IPO underpricing in a sample of VC-backed IPOs. We contribute to

the accounting literature by also documenting the significant corporate governance role of a

relatively unstudied external monitor—the venture capitalistVC. We further enhance extant

accounting and auditing research by providing evidence of non-regulatory means for enhancing




                                                                                                   40
monitoring of IPO firms. We also provide first time evidence of how IPO underpricing varies

according to various proxies for VC quality in the presence of the external auditor.

       Currently, we are extending this study to examine in more detail the interaction between

the presence of a VC and the role of the auditor in providing an information signal separate from

the insurance signal role in the IPO setting. In future studies, we intend to examine in more

detail VC-specific characteristics and how the VC’s impact on the audit and reporting function

varies with these traits in the IPO setting.




                                                                                                 41
42
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                                                                                              45
46
                                          Table 1
                                  Descriptive Statistics
The sample is comprised of 261 domestic IPO firms raising $10 million or less for the period
1993-1994.

Panel A: IPO Descriptive Statistics by Venture and Non-Venture-Backed                                                  Formatted Table

Variables          Total (n = 261) Venture-          Non-Venture    Difference in
                                      Backed         Backed (n =    mean
                                      (n = 41)       220)           (median)
Ln(Underpricing) 0.109                0.057          0.118           -1.606
                   (0.042)            (0.033)        (0.043)        (-0.804)

%Retained                 44.615                40.934                45.363                 -1.250
                          (47.1)                (41.8)                (48.7)                (-1.288)

LowIB                     0.912                 0.829                 0.927                  -2.041**
                          (1.000)               (1.000)               (1.000)
Unit                      0.398                 0.268                 0.423                  -1.860*
                          (0.000)               (0.000)               (0.000)
1/Price                   0.191                 0.187                 0.191                  -0.481
($)                       (0.196)               (0.185)               (0.199)               (-0.602)
Proceeds                  6.210                 6.737                 6.111                 1.979*
($mill)                   (6.000)               (6.200)               (6.000)               (1.660)*

E(Non)LOWSM  0.230                              0.049                 0.264                 -3.043***
             (0.000)                            (0.000)               (0.000)
UE(Non)LOWLG 0.142                              0.049                 0.159                 -1.864*
             (0.000)                            (0.000)               (0.000)
***, **, *
         denotes two-tailed significance at the 1%, 5% and 10% levels, respectively. White (1980)-consistent t-
statistics are in parentheses.

Ln(Underpricing)           = Ln(1 + market-adjusted first-day initial return);
%Retained                  = percentage ownership retained by pre-IPO shareholders;
LowIB                      = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0 (low quality), and zero
                           otherwise: where Carter, Dark, and Singh ranking is an update of the Carter and Manaster
                           (1990) proxy for underwriter reputation based on the position of the firm’s name in IPO
                           “Tombstone” announcements in the business press. This proxy ranges from 0.0 to 9.0 and
                           the 6.0 cutoff for low reputation is from Schultz (1993);
Unit                       = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise);
1/Price                    = reciprocal of the IPO offer price per share or per unit;
Proceeds                   = IPO gross proceeds;
Proceeds                   = IPO gross proceeds;
Ln(Assets)                 = Ln(pre-IPO total assets);
Leverage                   = long-term debt divided by total assets (pre-IPO);
FSubs                      = 1 if issuer has foreign subsidiaries, and 0 otherwise;
Ln(Underpricing)           = LN(1 + market-adjusted first-day initial return);
VBIPO                      = 1 if the IPO is backed by a VC, and zero otherwise;
%Retained                  = percentage ownership retained by pre-IPO shareholders;
LowIB                      = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0, and zero otherwise: where
                           Carter, Dark, and Singh ranking is an update of the Carter and Manaster (1990) proxy for


                                                                                                                  47
                           underwriter reputation based on the position of the firm’s name in IPO “Tombstone”
                           announcements in the business press. This proxy ranges from 0.0 to 9.0 and the 6.0 cutoff
                           for low reputation is from Schultz (1993);
Unit                       = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise);
1/Price                    = reciprocal of the IPO offer price per share or per unit;
E(Non-national)LOWSM = for OLS equals 1 if a non-national auditor and gross proceeds less than or equal to $6
                           million (sample median), and zero otherwise;
for 2SLS equals 1 if a non-national auditor is associated with the IPO and this association is predicted with a
                           probablility greater than 0.5 by the first-stage probit;
UE(Non-national)LOWLG                = for OLS equals 1 if a non-national auditor and gross proceeds greater than $6
                           million (sample median), and zero otherwise;
for 2SLS equals 1 if a non-national auditor is associated with the IPO but this association is not predicted with a
                           probablility greater than 0.5 by the first-stage probit.




                                                                                                                 48
Panel B: IPO Descriptive Statistics by DSE and Non-DSE                             Formatted: Font: Bold

Variables                             DSE (n=41)    Non-DSE   Difference in        Formatted: Font: Bold
                                                    (n=221)   mean                 Formatted Table
                                                              (median)             Formatted: Font: Bold
Ln(Underpricing)                  0.123          0.106         0.458               Formatted: Font: Bold
                                  (0.056)        (0.039)      (0.343)              Formatted: Font: Bold
%Retained                         36.014         46.100        -2.726***
                                                                                   Formatted: Font: Bold
                                  (32.000)       (48.900)     (-2.779)***
                                                                                   Formatted: Superscript
LowIB                             0.976          0.900         1.569
Unit                              0.537          0.373         1.975**
1/Price                           0.189          0.191         -0.125
($)                               (0.185)        (0.198)      (-0.225)
Proceeds                          6.695          6.119          1.765*
($mill)                           (6.500)        (6.000)       (1.996)**           Formatted: Superscript
Riskf                             17.318         13.721         2.177**            Formatted: Superscript
                                  (20.000)       (16.000)      (2.561)**           Formatted: Superscript
S1                                0.341          0.241          1.352
LOWSM                             0.098          0.255         -2.205**            Formatted: Superscript
LOWLG                             0.293          0.114          3.060***           Formatted: Superscript
Panel C: IPOs by Venture/Non-Venture Backed and DSE/Non-DSE                        Formatted: Font: Bold
                                  VC-Backed      Non-VC-      All
                                                 Backed
                   DSE            6              35           41
                   Non-DSE        35             185          220
                   All            41             220          261




                                                                              49
Panel B: IPOs by Venture/Non-Venture Backed and DSE/Non-DSE
                               VC-Backed      Non-VC-       All
                                              Backed
                DSE            6              35            41
                Non-DSE        35             185           220
                All            41             220           261


***, **, *
        denotes two-tailed significance at the 1%, 5% and 10% levels, respectively.
 White (1980)-consistent t-statistics are in parentheses.
Ln(Underpricing)            = LN(1 + market-adjusted first-day initial return);
%Retained                   = percentage ownership retained by pre-IPO shareholders;
LowIB                       = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0, and zero otherwise: where
                            Carter, Dark, and Singh ranking is an update of the Carter and Manaster (1990) proxy for
                            underwriter reputation based on the position of the firm’s name in IPO “Tombstone”
                            announcements in the business press. This proxy ranges from 0.0 to 9.0 and the 6.0 cutoff
                            for low reputation is from Schultz (1993);
Unit                        = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise);
1/Price                     = reciprocal of the IPO offer price per share or per unit;
Proceeds                    = IPO gross proceeds;
Proceeds                    = IPO gross proceeds;
#RiskfFactors                         = number of risk factors listed in the IPO prospectus;                            Formatted: Footnote Text
S-1                         = 1 if issuer files an S-1 registration, and 0 otherwise;
Ln(Assets)                  = Ln(pre-IPO total assets);
Leverage                    = long-term debt divided by total assets (pre-IPO);
FSubs                       = 1 if issuer has foreign subsidiaries, and 0 otherwise;
Ln(Underpricing)            = LN(1 + market-adjusted first-day initial return);
VBIPO                       = 1 if the IPO is backed by a VC, and zero otherwise;
%Retained                   = percentage ownership retained by pre-IPO shareholders;
LowIB                       = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0, and zero otherwise: where
                            Carter, Dark, and Singh ranking is an update of the Carter and Manaster (1990) proxy for
                            underwriter reputation based on the position of the firm’s name in IPO “Tombstone”
                            announcements in the business press. This proxy ranges from 0.0 to 9.0 and the 6.0 cutoff
                            for low reputation is from Schultz (1993);
Unit                        = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise);
1/Price                     = reciprocal of the IPO offer price per share or per unit;
E(Non-national)LOWSM = for OLS equals 1 if a non-national auditor and gross proceeds less than or equal to $6
                            million (sample median), and zero otherwise;
for 2SLS equals 1 if a non-national auditor is associated with the IPO and this association is predicted with a
                            probablility greater than 0.5 by the first-stage probit;
UE(Non-national)LOWLG                 = for OLS equals 1 if a non-national auditor and gross proceeds greater than $6
                            million (sample median), and zero otherwise;
for 2SLS equals 1 if a non-national auditor is associated with the IPO but this association is not predicted with a
                            probablility greater than 0.5 by the first-stage probit.
DSE                         = firm is a development-stage company;
Non-DSE                     = firm is not a development-stage company;
VC-Backed                   = IPO firm is backed by a venture capitalistVC; and
Non-VC-backed               = IPO firm is not backed by a venture capitalistVC.




                                                                                                                  50
                                                                  Table 2                                                                                               Formatted: Left: 0.9", Right: 0.9", Top: 1",
                                                                                                                                                                        Bottom: 0.38", Width: 11", Height: 8.5"
                            Correlation Table – Pearson (Spearman) Correlations are below (above) the diagonal
          Variable         VBIPO      DSE        LOWSM LOWLG %Retaine LowIB                 Unit       1/Price                                Proceeds                  Formatted: Font: 12 pt
                                                                      d                                                                                                 Formatted: Indent: Left: 0.26"
          VBIPO            1.000      -0.013     -0.186    -0..115    -0.085     -0.126     -0.115     -0.037                                 0.103                     Formatted: Font: 12 pt
                                      (0.838)    (.0026)   (0.063)    (0.196)    (0.042)    (0.064)    (0.548)                                (0.097)                   Formatted: Indent: Left: 0.26"
          DSE              -0.013     1.000      -0.136     0.187     -0.183     0.097      0.122      -0.014                                 0.124                     Formatted: Font: 12 pt
                           (0.838)               (0.028)   (0.002)    (0.005)    (0.118)    (0.049)    (0.823)                                (0.046)                   Formatted: Indent: Left: 0.26"
          LOWSM            -0.185     -0.135     1.000     -0.222     -0.002      0.074      0.188      0.231                                 -0.513
                                                                                                                                                                        Formatted: Font: 12 pt
                           (.0026)    (.0238)              (0.003)    (.981)     (0.237)    (0.002)    (0.000)                                (0.000)
                                                                                                                                                                        Formatted: Indent: Left: 0.26"
          LOWLG            -0.115      0.186     -0.222    1.000      -0.108      0.088      0.118     -0.010                                  0.309
                                                                                                                                                                        Formatted: Font: 12 pt, Not Bold
                           (.0634)    (.0024)    (.0003)              (0.102)    (0.158)    (0.057)    (0.885)                                (0.000)
          %Retained        -0.082     -0.177      0.011    -0.103     1.000      -0.029     -0.061     -0.049                                 -0.128                    Formatted: Font: 12 pt

                           (0.213)    (0.007)    (0.866)   (0.119)               (0.663)    (0.356)    (0.456)                                (0.053)                   Formatted: Font: 12 pt
          LowIB            -0.126     0.097       0.074     0.088     -0.015     1.000      0.225      0.374                                  -0.199                    Formatted: Indent: Left: 0.26"
                           (0.042)    (0.118)    (0.238)   (0.158)    (0.825)               (0.000)    (0.000)                                (0.001)                   Formatted: Font: 12 pt, Not Bold
          Unit             -0.115     0.122       0.188     0.118     -0.039     0.225      1.000      0.343                                  -0.147                    Formatted: Font: 12 pt
                           (0.064)    (0.050)    (0.002)   (0.057)    (0.552)    (0.000)               (0.000)                                (0.018)                   Formatted: Font: 12 pt
          1/Price          -0.030     -0.008      0.247    -0.019     -0.055     0.357      0.349      1.000                                  -0.358                    Formatted: Indent: Left: 0.26"
                           (0.631)    (0.901)    (0.000)   (0.749)    (0.409)    (0.000)    (0.000)                                           (0.000)
                                                                                                                                                                        Formatted: Font: 12 pt, Not Bold
          Proceeds         0.118      0.109      -0.490     0.259     -0.130     -0.209     -0.153     -0.343                                 1.000
                                                                                                                                                                        Formatted: Font: 12 pt, Not Bold
                           (0.056)    (0.079)    (0.000)   (0.000)    (0.049)    (0.001)    (0.013)    (0.000)
p-values are provided in the parentheses.                                                                                                                               Formatted: Font: 12 pt
VBIPO                      = 1 if the IPO is backed by a VC, and zero otherwise;                                                                                        Formatted: Font: 12 pt
DSE                        = firm is a development-stage company;
                                                                                                                                                                        Formatted: Font: 12 pt
%Retained                  = percentage ownership retained by pre-IPO shareholders;
LowIB                      = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0, and zero otherwise: where Carter, Dark, and Singh ranking is an update of    Formatted: Indent: Left: 0.26"
                           the Carter and Manaster (1990) proxy for underwriter reputation based on the position of the firm’s name in IPO “Tombstone”                  Formatted: Font: 12 pt
                           announcements in the business press. This proxy ranges from 0.0 to 9.0 and the 6.0 cutoff for low reputation is from Schultz (1993);
                                                                                                                                                                        Formatted: Indent: Left: 0.26"
Unit                       = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise);
1/Price                    = reciprocal of the IPO offer price per share or per unit;                                                                                   Formatted: Font: 12 pt
Proceeds                   = IPO gross proceeds;                                                                                                                        Formatted: Indent: Left: 0.26"
#RiskFactorsf                        = number of risk factors listed in the IPO prospectus;                                                                             Formatted: Font: 12 pt
S-1                        = 1 if issuer files an S-1 registration, and 0 otherwise;
Ln(Assets)                 = Ln(pre-IPO total assets);                                                                                                                  Formatted: Indent: Left: 0.26"
Leverage                   = long-term debt divided by total assets (pre-IPO);
FSubs                      = 1 if issuer has foreign subsidiaries, and 0 otherwise;
Ln(AuditFee)               = Ln(Auditor compensation for IPO engagement);
                                                                                                                                                                   51
Opinion              = 1 if a going-concern audit opinion, and 0 otherwise;
Ln(Underpricing)     = LN(1 + market-adjusted first-day initial return);
VBIPO                = 1 if the IPO is backed by a VC, and zero otherwise;
%Retained            = percentage ownership retained by pre-IPO shareholders;
LowIB                = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0, and zero otherwise: where Carter, Dark, and Singh ranking is an update of
                     the Carter and Manaster (1990) proxy for underwriter reputation based on the position of the firm’s name in IPO “Tombstone”
                     announcements in the business press. This proxy ranges from 0.0 to 9.0 and the 6.0 cutoff for low reputation is from Schultz (1993);
Unit                 = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise);
1/Price              = reciprocal of the IPO offer price per share or per unit;
E(Non-national)LOWSM = for OLS equals 1 if a non-national auditor and gross proceeds less than or equal to $6 million (sample median), and zero otherwise; for
                     2SLS equals 1 if a non-national auditor is associated with the IPO and this association is predicted with a probablilityprobability greater
                     than 0.5 by the first-stage probit;
UE(Non-national)LOWLG          = for OLS equals 1 if a non-national auditor and gross proceeds greater than $6 million (sample median), and zero otherwise; for
                     2SLS equals 1 if a non-national auditor is associated with the IPO but this association is not predicted with a probablilityprobability
                     greater than 0.5 by the first-stage probit.
DSE                  = firm is a development-stage company;




                                                                                                                                                             52
53
54
                                           Table 3
         Small IPO Underpricing and Venture Capital Presence and Auditor Choice                       Formatted: Indent: First line: 0.5"
  The sample is comprised of 261 domestic IPO firms raising $10 million or less for the               Formatted: Centered
period 1993-1994. OLS and 2SLS results are presented in Panel B. In the two-stage least
    squares regression version of regression Model(1), we determine the probability of
  selecting a nonnational auditor using the estimated parameters from the auditor choice
regression (regression 2). The variable E(Nonnational) (UE(Nonnational)) equals one if
 a nonnational auditor is associated with the IPO and this association is (is not) predicted
                with a probability greater than 0.5 by regression Model (2).

                                      1 if Non-national
                                  0 if Big 6/ Second Tier Auditor

      0  1 PROCEEDS   2 RISKFi   3 S1i   4 LN ( Assets) i   5 LEVi   6 FSubsi   i
                       i



      Ln(Underpricing ) i   0  1VBIPO   2 %RETAINED   3 LOWIBi   4UNITi
                                         i               i

                             51 / PRICEi   6 E ( Nonnational ) i   7UE( Nonnational ) i   i

                    Panel A: First-Stage Auditor Choice Regression                                    Formatted: Centered
         Variable                        DSE                       Non-DSE                            Formatted: Centered
         Constant                        1.078                       1.239                            Formatted: Centered
                                        (0.904)                    (3.641)***

         Proceeds                           -0.057                           -0.246                   Formatted: Centered
                                           (-0.422)                        (-4.556)***

           Riskf                            -0.021                            0.006                   Formatted: Centered
                                           (-0.896)                          (0.650)

            S-1                             -1.452                            -0.245                  Formatted: Centered
                                          (-2.434)**                         (-1.019)

        Ln (Assets)                         0.052                             -0.100                  Formatted: Centered
                                           (0.265)                           (-1.504)

         Leverage                           -0.292                            0.109                   Formatted: Centered
                                           (-0.802)                          (1.223)

           Fsubs                                                              0.220                   Formatted: Centered
                                                                             (0.977)

   Likelihood Ratio   2                    9.54*                            37.51***                 Formatted: Centered
      Observations                           41                                220                    Formatted: Centered




                                                                                              55
               Small IPO Underpricing—VC Presence and Auditor Choice
                           DSE versus Non-DSE IPO Firms
The sample is comprised of 261 domestic IPO firms raising $10 million or less for the period 1993-1994.       Formatted: Font: Times, 10 pt
The DSE subsample serves as a control for the informational demands by the IPO market, such that only
the insurance demands should be relevant. The Non-DSE sample should exhibit both informational and
insurance demands of the IPO market                                                                           Formatted: Font: Times, 10 pt, Bold
Ln(Underpricing )i   0  1VBIPO   2 %RETAINED  3 LOWIBi   4UNITi  51/ PRICEi
                                  i               i

                         6 LOWSM  7 LOWLG   i
                                                                                                              Formatted: Font: Bold
Panel B: IPO Underpricing Regression (OLS and 2SLS results)
                          DSE (insurance demands     Non-DSE (insurance and                                   Formatted: Left
                          only)                      information demands)
                           OLS          2SLS         OLS           2SLS
Constant                   0.068        0.093        -0.118        -0.122
                           (0.511)      (0.712)      (-1.719)*     (-1.739)*                                  Formatted: Footer
VBIPO                      -0.081       -0.071       -0.062        -0.060
                           (-0.790)     (-0.687)     (-2.432)**    (-2.490)**
%Retained                  -0.003       -0.004       0.003         0.003
                           (-1.602)     (-1.689)     (2.712)***    (2.735)***
LowIB                      0.158        0.121        0.017         0.017
                           (1.184)      (0.957)      (0.483)       (0.480)
Unit                       0.006        -0.019       0.004         0.003
                           (0.053)      (-0.180)     (0.106)       (0.008)
1/Price                    0.161        0.346        0.485         0.491
                           (0.137)      (0.262)      (1.457)       (1.535)
E(Nonnational)LOWSM        -0.179       -0.170       -0.017        -0.014
                           (-1.437)     (-0.757)     (-0.350)      (-0.273)
UE(Nonnational)LOWLG 0.612              0.075        0.108         0.114
                           (0.419)      (0.509)      (1.796)*      (1.868)*
Observations               41                        220
Adjusted-R2                17.50%       14.75%       9.74%         9.85%
***, **, *
        denotes two-tailed significance at the 1%, 5% and 10% levels, respectively.
 White (1980)-consistent t-statistics are in parentheses.
Proceeds                    = IPO gross proceeds;
#RiskFactors                = number of risk factors listed in the IPO prospectus;
S-1                         = 1 if issuer files an S-1 registration, and 0 otherwise;
Ln(Assets)                  = Ln(pre-IPO total assets);
Leverage                    = long-term debt divided by total assets (pre-IPO);
FSubs                       = 1 if issuer has foreign subsidiaries, and 0 otherwise;
Ln(Underpricing)            = LN(1 + market-adjusted first-day initial return);
VBIPO                       = 1 if the IPO is backed by a VC, and zero otherwise;
%Retained                   = percentage ownership retained by pre-IPO shareholders;
LowIB                       = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0, and zero
                            otherwise: where Carter, Dark, and Singh ranking is an update of the Carter and
                            Manaster (1990) proxy for underwriter reputation based on the position of the
                            firm’s name in IPO “Tombstone” announcements in the business press. This
                            proxy ranges from 0.0 to 9.0 and the 6.0 cutoff for low reputation is from
                            Schultz (1993);
Unit                        = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise;
1/Price                     = reciprocal of the IPO offer price per share or per unit;


                                                                                                         56
E(Non-national)LOWSM = for OLS equals 1 if a non-national auditor and gross proceeds less than or
                            equal to $6 million (sample median), and zero otherwise;
for 2SLS equals 1 if a non-national auditor is associated with the IPO and this association is predicted with
                            a probablility greater than 0.5 by the first-stage probit;
UE(Non-national)LOWLG                          = for OLS equals 1 if a non-national auditor and gross
proceeds greater than $6 million
                            (sample median), and zero otherwise; for 2SLS equals 1 if a non-national             Formatted: Indent: Left: 1", First line: 0.5"
                  auditor is associated with the IPO but this association is not predicted with a probablility
                  greater than 0.5 by the first-stage probit.
                                                                                                                 Formatted: Indent: Left: 1", First line: 0.5",
                                                                                                                 Tab stops: 1.5", Left
                                                                                                                 Formatted: Indent: Left: 1", First line: 0.5"
                                                                                                                 Formatted: Normal, Indent: Left: 1"




                                                                                                            57
     Formatted: Indent: Left: 1", First line: 0.5"
     Formatted: Normal, Centered, Indent: Left:
     0", First line: 0"




58
                                      TTable 4                                                            Formatted: Font: Bold
               Small IPO Underpricing—VC Presence and Auditor Choice
                           VC versus Non-VC backed IPOs
The sample is comprised of 261 domestic IPO firms raising $10 million or less for the period 1993-1994.   Formatted: Font: Times, 10 pt
The VC sub-sample serves as a control for the information demands by the IPO market, such that only the
insurance demands should be relevant. The Non-VC sample should exhibit both informational and
insurance demands of the IPO market                                                                       Formatted: Font: Times, 10 pt, Bold
Ln(Underpricing )i   0  1VBIPO   2 %RETAINED  3 LOWIBi   4UNITi  51 / PRICEi
                                  i               i

                       6 LOWSMi  7 LOWLGi   i
      Ln(Underpricing ) i   0  1VBIPO   2 %RETAINED   3 LOWIBi   4UNITi
                                         i               i

                        51 / PRICEi   i
Panel A: First-Stage Auditor Choice Regression
Variable

Constant                           0.911
                                   (2.995)***

Proceeds                           -0.167
                                   (-3.672)***

RiskF                              0.002
                                   (0.212)

S1                                 -0.524
                                   (-2.542)**

LNTA                               -0.067
                                   (-1.105)

Lev                                0.011
                                   (0.227)

Fsub                               0.911
                                   (2.995)***

Observations                       261
Adjusted-R2                        8.64%




                                                                                                     59
Panel B: IPO Underpricing Regression (OLS and 2SLS results)
                          VC-Backed (insurance      Non-VC-Backed                                                Formatted: Indent: First line: 0"
                          only)                     (information and
                                                    insurance)
                          OLS           2SLS        OLS           2SLS
Constant                  0.005         -0.007      -0.097        -0.095
                          (0.058)       (-0.087)    (-1.023)      (-1.009)
%Retained                 0.001         0.001       0.002         0.002
                          (1.291)       (1.462)     (1.956)*      (1.966)*

LowIB                                0.060              0.056              0.026              0.026
                                     (1.111)            (1.047)            (0.331)            (0.328)
Unit                                 -0.019             -0.007             -0.007             -0.014
                                     (-0.474)           (-0.183)           (-0.177)           (-0.358)
1/Price                              -0.315             -0.279             0.598              0.562
                                     (-0.821)           (-0.726)           (1.646)            (1.567)
E(Nonnational)LOWSM                  -0.073             -0.082             -0.039             -0.016
                                     (-0.964)           (-1.116)           (-0.870)           (-0.348)
UE(Nonnational)LOWLG                 0.109              0.116              0.096              0.108
                                     (1.307)            (1.410)            (1.809)*           (2.028)**
Observations                         41                                    220
Adjusted-R2                          5.30%                                 2.47%
***, **, *
        denotes two-tailed significance at the 1%, 5% and 10% levels, respectively.
 White (1980)-consistent t-statistics are in parentheses.
Proceeds                    = IPO gross proceeds;
#RiskFactors                = number of risk factors listed in the IPO prospectus;
S-1                         = 1 if issuer files an S-1 registration, and 0 otherwise;
Ln(Assets)                  = Ln(pre-IPO total assets);
Leverage                    = long-term debt divided by total assets (pre-IPO);
FSubs                       = 1 if issuer has foreign subsidiaries, and 0 otherwise;
Ln(Underpricing)            = LN(1 + market-adjusted first-day initial return);
VBIPO                       = 1 if the IPO is backed by a VC, and zero otherwise;
%Retained                   = percentage ownership retained by pre-IPO shareholders;
LowIB                       = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0, and zero
                            otherwise: where Carter, Dark, and Singh ranking is an update of the Carter and
                            Manaster (1990) proxy for underwriter reputation based on the position of the
                            firm’s name in IPO “Tombstone” announcements in the business press. This
                            proxy ranges from 0.0 to 9.0 and the 6.0 cutoff for low reputation is from
                            Schultz (1993);
Unit                        = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise);
1/Price                     = reciprocal of the IPO offer price per share or per unit;
E(Non-national)LOWSM = for OLS equals 1 if a non-national auditor and gross proceeds less than or                Formatted: Indent: Left: 0", First line: 0"
equal to $6
                             million (sample median), and zero otherwise;; for 2SLS equals 1 if a non-
                            national auditor is associated with the IPO and this association is predicted with
                            a probablility greater than 0.5 by the first-stage probit;
                                                                                                                 Formatted: Indent: Left: 0", First line: 0"
UE(Non-national)LOWLG         = for OLS equals 1 if a non-national auditor and gross proceeds greater
                     than $6 million (sample median), and zero otherwise.; for 2SLS equals 1 if a
                     non-national auditor is associated with the IPO but this association is not
                     predicted with a probablility greater than 0.5 by the first-stage probit.


                                                                                                            60
                                         Table 5
             Small IPO Underpricing—Venture CapitalistVC and Auditor Presence
                                 The Relative Size of Deals
The sample is comprised of 261 domestic IPO firms raising $10 million or less for the period 1993-1994.         Formatted: Font: Times, 10 pt
The Smaller deal sub-sample serves as a control for the insurance demands by the IPO market, such that
only the information demands should be relevant. The Larger deals sample should exhibit both
informational and insurance demands of the IPO market. Smaller deals are defined as deals less then or
equal to the median deal size for the sample of $6 million. Larger deals are defined as deals greater than or
equal to the median deal size of $6 million.

              Ln(Underpricing )i   0  1VBIPO   2 %RETAINED  3 LOWIBi
                                                i               i

                                    4 NONNATIONALi  5UNITi  61/ PRICEi   i

              Variables                      Smaller Deals                         Larger Deals
              Constant                           0.067                                -0.040
                                                (0.719)                              (-0.418)
               VBIPO                             -0.117                               -0.018
                                              (-2.975)***                             (0.626)

              %Retained                            0.002                                0.002
                                                  (0.958)                              (1.718)*

               LowIB                              -0.099                                0.049
                                                 (-1.513)                              (1.626)

             Nonnational                          -0.058                                0.109
                                                 (-1.072)                             (2.077)**

                 Unit                             -0.015                                -0.003
                                                 (-0.326)                              (-0.063)

               1/Price                             0.309                                0.693
                                                  (0.727)                              (1.310)

                 N                                  138                                  123
               Adj.-R2                             0.051                                0.139
***, **, *
         denotes two-tailed significance at the 1%, 5% and 10% levels, respectively. White (1980)-consistent
t-statistics are in parentheses.




                                                                                                          61
Large Deal         = gross proceeds greater than $6 million (sample median);
Small Deal         = gross proceeds less than or equal to $6 million (sample median);
Ln(Underpricing)   = LN(1 + market-adjusted first-day initial return);
VBIPO              = 1 if the IPO is backed by a VC, and zero otherwise;
%Retained          = percentage ownership retained by pre-IPO shareholders;
LowIB              = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0, and zero
                   otherwise: where Carter, Dark, and Singh ranking is an update of the Carter and
                   Manaster (1990) proxy for underwriter reputation based on the position of the
                   firm’s name in IPO “Tombstone” announcements in the business press. This
                   proxy ranges from 0.0 to 9.0 and the 6.0 cutoff for low reputation is from
                   Schultz (1993);
Unit               = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise);
1/Price            = reciprocal of the IPO offer price per share or per unit;
Nonnational        =1 if a nonnational auditor (low quality) is associated with the IPO, and zero
                    otherwise.                                                                       Formatted: Indent: Left: 1", First line: 0.5"




                                                                                                62
                                        Table 6
                          Small IPO Auditor Compensation
   The sample is comprised of 261 domestic IPO firms raising $10 million or less for the                Formatted: Centered
                                   period 1993-1994.

Ln( AuditFee)   0  1VBIPO  2 Ln( Assets)   3 Invrec   4 S1   5 Sqsubs   6 FSub
                      7 Opinion   8 Big6   9 Ln(Pr oceeds)  



     Variables                         DSEs                                    Non-DSEs
     Constant              10.684                 9.095                 10.583           9.361
                         (38.185)***            (8.958)***            (89.112)***    (32.610)***
       VBIPO                0.379                 0.322                  0.028           -0.051
                           (0.868)               (0.829)                (0.169)        (-0.315)
    Ln(Assets)              -0.065                -0.123                 0.074           0.063
                          (-0.644)               (-1.580)               (1.331)         (1.129)
        Invrec              0.000                 -0.000                 0.000           0.000
                           (0.060)               (-0.921)              (1.666)*         (0.840)
                            0.373                 0.466                  0.260           0.123
         Ss1               (1.056)               (1.467)               (1.779)*         (0.864)
        Sqsubs              0.629                 0.928                  0.024           -0.032
                          (2.039)*              (2.139)**               (0.281)        (-0.417)
        FSubs               -0.629                -1.166                 0.286           0.294
                          (-1.309)               (-1.675)              (2.149)**      (2.510)**
      Opinion               -0.301                -0.413                 0.139           0.096
                          (-0.925)               (-1.419)               (0.659)         (0.468)
             Big6           0.039                 0.162                  0.374           0.211
                           (0.127)               (0.554)                (3.420)        (1.798)*
 Ln(Proceeds)                                     0.865                                  0.809
                                                 (1.693)                              (4.306)***

  Observations                41                                           220
    Adj.-R2                 0.349                  0.497                  0.224            0.317
***, **, *
      denotes two-tailed significance at the 1%, 5% and 10% levels, respectively.
White (1980)-consistent t-statistics are in parentheses.

Ln(AuditFee)               = Ln(Auditor compensation for IPO engagement);
VBIPO                      = 1 if the IPO is backed by a VC, and zero otherwise;
Invrec                     = (Inventory + Trade receivables)/Total assets;
s1                         = 1 if issuer files an S-1 registration, and 0 otherwise;
Sqsubs                     = square root of the number of subsidiaries;
Fsubs                      = 1 if issuer has foreign subsidiaries, and 0 otherwise;
Opinion                    = 1 if a going-concern audit opinion, and 0 otherwise;
Big6                       = 1 if a Big Six auditor (high quality), and 0 otherwise; and
Ln(Proceeds)               = Ln(IPO gross proceeds).




                                                                                                   63
                                            Table 7
        Small IPO Underpricing—Venture Capital Quality and Auditor Choice
 The sample is comprised of 261 domestic IPO firms raising $10 million or less for the
 period 1993-1994. This regression examines the impact of variation in VC-specific traits
 (instead of only inserting an indicator variable for VC presence) on the first day
 underpricing of small size IPO deals.

  Ln(Underpricing )i   0  1DSE   2VCCHARi  3 DSEi _ VCCHARi   4 %RETAINEDi

                      5 LOWIBi  6UNITi  71/ PRICEi  8 LOWSMi  9 LOWLGi   i

  Variables               [1]              [2]                [3]               [4]
  Constant              -0.079           -0.091             -0.085            -0.098
                       (-1.23)           (-1.34)            (-1.32)           (-1.52)
     DSE                0.006             0.022              0.015             0.019
                        (0.13)           (0.45)             (0.32)            (0.41)
VC Board Rep.          -0.0114
                      (-2.81)***
DSE*VC Board            0.037
     Rep               (2.11)**
VC Investment                             -0.366
                                        (-3.82)***
 DSE * VC                                 -1.313
 Investment                              (-1.51)
   VC Age                                                  -1.20e-05
                                                          (-3.10)***
DSE* VC Age                                               -1.150e-05
                                                            (-0.87)
VC Experience                                                               -5.050e-05
                                                                              (-1.40)
  DSE*VC                                                                    -1.762e-05
 Experience                                                                   (-1.35)
 %Retained              0.002             0.002             0.002              0.002
                       (2.03)**          (1.81)*           (1.98)**          (2.10)**
    LowIB               0.025             0.036             0.032              0.038
                        (0.78)           (1.15)             (1.00)            (1.22)
     Unit               -0.002           -0.005             -0.004            -0.002
                       (-0.05)           (-0.15)           (-0.14)            (-0.06)
   1/Price              0.434             0.475             0.442              0.429
                        (1.30)           (1.32)             (1.31)            (1.26_
  LOWSM                 -0.026           -0.022             -0.026            -0.024
                       (-0.56)           (-0.46)           (-0.55)            (-0.52)
  LOWLG                 0.112             0.105             0.109              0.112
                       (1.97)*           (1.84)*           (1.93)*            (1.97)*

   Adj. R2              0.071             0.063             0.068             0.063


                                                                                         64
***, **, *
        denotes two-tailed significance at the 1%, 5% and 10% levels, respectively.
 White (1980)-consistent t-statistics are in parentheses.
Ln(Underpricing)            = LN(1 + market-adjusted first-day initial return);
VCCHAR                      = VC board representation (the number of board seats held by the VC); VC pre-
                            IPO investment (the amount of pre-IPO VC investment as a proportion of the
                            total proceeds of the IPO); VC age (the time period from the inception of the VC
                            firm to date of the IPO); and VC IPO experience (the number of other IPOs that
                            the VC firm has been involved with prior to the current IPO);
%Retained                   = percentage ownership retained by pre-IPO shareholders;
LowIB                       = 1 if Carter, Dark, and Singh (1994) ranking is less than 6.0, and zero
                            otherwise: where Carter, Dark, and Singh ranking is an update of the Carter and
                            Manaster (1990) proxy for underwriter reputation based on the position of the
                            firm’s name in IPO “Tombstone” announcements in the business press. This
                            proxy ranges from 0.0 to 9.0 and the 6.0 cutoff for low reputation is from
                            Schultz (1993);
Unit                        = 1 if a unit IPO (e.g., shares and warrants, and zero otherwise;
1/Price                     = reciprocal of the IPO offer price per share or per unit;
LOWSM                       = equals 1 if a non-national auditor and gross proceeds less than or equal to $6
                            million (sample median), and zero otherwise;
LOWLG                       = equals 1 if a non-national auditor and gross proceeds greater than $6 million
                            (sample median), and zero otherwise;




                                                                                                         65
Additional thoughts/questions to resolve by Monday:

   1. Finalize the red notes in the intro section and in the rest of the body of the
      paper…
   2. See if how I tried to deal with the prior IPO lit stuff is okay with you.
   3. Fix the footnote numbering problem (they jump from #3 to #7)
   4. Table 1, Panel A… are there really no medians for dummies?
   5. Table 1, panel C.. get rid of table and discussion… x2 probably not significant,
      doesn’t add anything to the paper…
   6. Table 2 correlations, get rid of all variables from the auditor comp regression…
      (get rid of them from the descriptives tables too…).they just confuse the reader…
      in fact I think we should take the auditor comp table out and just discuss that we
      replicated it and what we found, not tabulated… what do you think… I just don’t
      think it adds that much…. That is needs its own table???
   7. I now think we should leave Table 7 in… it is more of our unique contribution
      than the auditor comp table…. Ya know???/ I actually think it does really add to
      the paper in the sense that it is our unique contribution to this area…..
   8. finalize abstract, intro and conclusion… I didn’t do anything to the conclusion,
      but I think we should really make sure they all have the PUNCH that they
      deserve…




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