3. METHODOLOGY
3.1 Hypothesis Development
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3. METHODOLOGY
3.1 Hypothesis Development
In this section, there are three hypotheses discussed and provided as follows:
3.1.1 The Relation between Underpricing and Strategic Alliances
In the light of prior theoretical literature, there are many factors leading to underpricing of initial public offerings. One of the theories is about asymmetric information. Beatty and Ritter (1986) cite Rock’s theory and introduce ex-ante uncertainty to measure the degree of asymmetric information. That is to say, when investors are conscious of more uncertainty about the value of IPOs, there is the greater degree of asymmetric information between investors. This means that as the ex ante uncertainty increases, potential investors have an incentive to do analysis to discriminate which issues are likely to appreciate in price.
Therefore, the problem of winner’s curse becomes acute. In order to prompt uninformed investors to invest in an offering with greater ex ante uncertainty, issuers have to underprice. And the empirical results show that there is a positive relation between the ex ante uncertainty and underpricing.
The reasons for high ex ante uncertainty are different. One of causes is the risks IPO firms encounter. There are generally no established histories of sales, earnings or cash flows for the firms going public. The biotech firms, particularly, face greater uncertainty and risk in IPO market because of intense competition, long period in research and development and great need for capital. Besides, in biotech IPOs the primary assets are intangibles which are notoriously difficult to value (Guo et al. 2005).
In order to mitigate investors’ concern, biotech firms will ally with major pharmaceutical and health care companies which have prominent marketing and
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sales expertise as well as financial capital that can support the firms through product development process (Pisano1991). In addition, alliances are widely observable and reflect the extent to which a firm’s resources and capabilities are in demand by other organizations which provides valuable market signal for investors (Jensen 2004).
Therefore, by means of strategic alliances, biotech firms will reduce the concern investors feel. And the ex ante uncertainty will be decreased to lessen the level of asymmetric information. Accordingly, this study hypothesizes that a negative relationship exists between strategic alliances and underpricing.
Hypothesis 1. Underpricing will be likely to decrease in biotech firms when there is a strategic alliance occurred before the IPO date.
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3.1.2 The Relation between Underpricing and Risk Factors
In prior research, for the purpose of analyzing the relation between underpricing and ex-ante uncertainty, some studies use risk factors in the prospectus as a proxy for ex-ante uncertainty. Beatty and Welch (1996) demonstrate that an increase in the quantity of potentially adverse disclosures proxied by the number of risks in the registration statement reduces the likelihood of a successful class-action lawsuit. Hence, firms citing more risk factors must increase IPO underpricing indicating that first-day investors must be compensated for accepting more firm caution. Moreover, Arnold et al. (2010) think that risk factors in the prospectus lack certainty. Management cannot declare that unknown future events will or will not happen. It is left to investors to consider what is likely to occur with respect to each risk. Therefore, the information disclosed in the risk factors section is ambiguous. And IPO issuers are without a public record about company news and returns. Investors are more likely to depend on the prospectus when making investment decisions and will expect a premium from firms that expose them to more ambiguous information.
Consequently, this study hypothesizes that there is a positive relation between underpricing and risk factors.
In order to measure risk factors in the prospectus, the first approach applied is on the basis of previous literature2 using a summated measure of different types of risk factors presented in the prospectus. This study compiles 20 items which commonly listed as risk factors from prior studies. Certo et al. (2001) consider that more risk factors generally indicate a higher risk position. And Arthurs et al. (2008) find that there is a positive relation between risk factors and
2 Beatty and Zajac (1994) ; Welbourne and Andrews (1996) ; Cyr, Johnson and Welbourne (2000) ; Certo, Covin, Daily and Dalton (2001)
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underpricing. Therefore, this study hypothesizes that the greater number of risk factors among 20 items presented in prospectus, the greater is underpricing.
In addition to analyzing the number of items listed in the risk factor section, the second approach is based on the literature about information disclosure and content analysis. Freedman and Stagliano (1992) suggest that the meaning of the message is what is important and what is included in the theme, rather than how much is said. Therefore, this study evaluates the content of each item in listed twenty risk factors by weighting score. The summation of disclosure score in each item presented indicates the level of a firm's risk. That is to say, if the disclosure score is higher, the level of a firm's risk is higher. Hence this study expects that the greater is the disclosure score of risk factors among 20 items presented in the prospectus, the greater is underpricing.
According to the above inference, the hypotheses are following:
Hypothesis 2.1 Underpricing becomes greater when the summated number of risk factors among twenty items increases.
2.2 Underpricing becomes greater when the summated disclosure score of risk factors among twenty items increases.
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3.1.3 The Relation between Underpricing and Risk Factors under Different Firm Size
In addition, the firm size may influence the relation between underpricing and risk factors because investors may prefer to find the information about larger firms owing to higher profits that investors can generate by trading in larger firms (Atiase 1980, 1985). In other words, there may be greater losses that large companies can bring about from facing the risks. And Atiase (1980) argues that the amount of private predisclosure information production and dissemination is an increasing function of firm size. Therefore, the impact of information disclosed in the prospectus provided for investors in larger firms will be more obvious. That is to say, the association between risk factors and underpricing will have a better effect. Accordingly, this study expects that considering the firm size, there is more likely to be a positive relation between underpricing and risk factors.
Hypothesis 3.1 Underpricing is more likely to become greater with larger firms than with smaller firms when the summated number of risk factors among twenty items increases.
3.2 Underpricing is more likely to become greater with larger firms than with smaller firms when the summated disclosure score of risk factors among twenty items increases.
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