2. LITERATURE REVIEW
3.3 Research Design
3.3.1 Approaches to Measure Risk Factors
firms), 2004 (28 firms) and 2006 (24 firms). And the proportionof firms in these three years is 43.72%. In Table 3-1Panel B, the largest industry is biotech industry in
2834 Pharmaceutical Preparations 127 54.98%
2835 In Vitro and In VivoDiagnostic Substances
7 3.03%
2836 Biological Products, Except Diagnostic Substances
66 28.57%
8731 Commercial Physical and Biological Research
31 13.42%
Total 231 100%
3.3 Research Design
3.3.1 Approaches to Measure Risk Factors
For the purpose of analyzing the influence of risk factors on IPO probability of profitability after IPO, this study adopts four approaches to measure 210 biotech firms from 1997 to 2012 to provide for a source of subsequent empirical analysis. This section is mainly to explain the content of the approaches. Referring to prior research on risk factors being a proxy for ex ante uncertainty, the first approach is to count the number of risk factors listed in the prospectus.Consistent with Beatty and Zajac (1994) considering a firm’s risk position is operationalized as the number of risk factors reported in the prospectus, the assumption is that while all risk factors are not equally
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impactful, more risk factors generally indicate a higher risk position.On the basis of previous research (e.g. Welboume and Andrews1996; Cyret al. 2000; Certo et al.
2001),the presence of the following twenty different types of risk factors commonly listed in the prospectus are included in this measure and are coded (i.e. 0 = No, 1 = Yes):
(1) Technological obsolescence/ rapid technological change (2) New product
(3) Few or limited products
(4) Low number of years in operation (5) Inexperienced management (6) Technical risk
(7) Seasonality
(8) Customer dependence (9) Supplier dependence (10) Inexperienced underwriters (11) Intense competition
(12) Legal proceedings against company (13) Liability
(14) Government regulation
(15) Manufacturing capacity limitations (16) Need for additional capital
(17) Uncertainty regarding patents or proprietary rights (18) Terminationof contract
(19) Dependence on key employees (20) Competitive labor markets
Although these twenty different types of risk factors are commonly listed in the prospectus, the oral committee gives advice to me that whether government regulation and inexperienced underwriters can removed from these classification. Because the disclosure of government regulation is mandatory and inexperienced underwriters is a bad news that firms are inclined not to disclose this information, each firm must disclose government regulation and not disclose inexperienced underwriters. Due to this, there is no difference in dealing with these two disclosures among firms in my sample. And after running the data, the results are exactly unsignificant. So whether or not I include them in the prospectors seems not so important. Therefore, I will take the advice of the
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oral committee as a good advice and take it into consideration in the future research.
In addition the method based on previous research (e.g. Welboume and Andrews1996; Cyret al. 2000; Certo et al. 2001), I want to discuss more, and turn to a more detailed analysis of the content of IPO risk declarations. Risk declarations are not just categorized by the method described above, but also by another kind of classification, by reference to the studies of Beattie et al. (2004), Beretta and Bozzolan (2004)
Accordingly, I undertake analyses based on both and discuss each in turn. First, I commence with an analysis of risk types by the twenty items. Second, I analyse risk types along the following dimensions: (i) financial/non-financial; (ii) quantitative/qualitative; (iii) uncertainty risks , and (iv) downside risks. These four dimensions are re-categorization of those twenty risk items.
The financial/non-financial dichotomy is classified by the criteria whether this risk factor is associated with financial issue. Across the sample, three types of risk factors are financial risk factors: (i) Legal proceedings against company; (ii) Liability, and (iii) Need for additional capital.
In respect of the quantitative/qualitative dichotomy, I find that across the sample a quantity tends to be specified for five types of risk: (i) Where a company is dependent on one or a few major customers or contracts (ii) Keyman insurance(companies who declare a dependence on key personnel, have indicated the amount of Keyman insurance taken out in respect of these personnel) (iii) Legal proceedings against company (iv) Liability (v) Need for additional capital
Risk declarations across our sample relate either to increased volatility or to a potential reduction in income/increase in costs and, therefore, we might categorize risks according to whether they express (i) uncertainty (upside and downside) or (ii) solely downside. The former would include statements, for example, that the sector is at an early stage of development or that sector demand in cyclical; the latter would include concerns over, for example, key employees leaving, competition from other businesses and inadequate financing being available for expansion, all of which would be expected to have a negative impact upon revenues.
I present the four subgroups of risk types in Table 3-2. Panel A deals with the financial/non-financial, Panel B with the quantitative/qualitative , Panel C with the uncertainty risks and Panel D with the downsides risks.
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In panel A the financial/non-financial dichotomy is classified by the criteria whether this risk factor is associated with financial issue. Across the twenty different types of risk factors commonly listed in the prospectus, three types of risk factors are financial risk factors: (i) Legal proceedings against company; (ii) Liability, and (iii) Need for additional capital. First, legal proceedings against company is acociated with firms’ allocation of fund. If firm has legal proceedings, it must effect operating performance of firm, due to limitation of fund using. If the legal proceedings are so large that firms may be short of money, therefore jeopardizing firms. The worst situation is bankruptcy. So I think that information about legal proceedings against company in the prospectus is kind of financial risk factor. Second, liability is also kind of financial issue. The reason firms have liabilities is due to lack of money. Only firms are short of money that they need to borrow money from others. In the future, firms must need to pay off liabilities, so they need to reserve some cash. However, this will affect performance of firms, because not all the money can free to use to support firms’
operating. Therefore, I think that this kind of risk is financial risk. At last, the firms’
need for additional capital are definitely the financial issue. It represent that firms are lack of money to operate, they wish that more investors can lend them money. Except for the three risk factors item described above, the remain seventeen risk factors are classified as non-financial risk factors.
In panel B the quantitative/qualitative dichotomy, I find that across the sample a quantity tends to be specified for five types of risk: (i) Where a company is dependent on one or a few major customers or contracts (ii) Keyman insurance(companies who declare a dependence on key personnel, have indicated the amount of Keyman insurance taken out in respect of these personnel) (iii) Legal proceedings against company (iv) Liability (v) Need for additional capital, so I select them from the twenty different types of risk factors commonly listed in the prospectus, and defined them as quantitative risk factors. The remainder are qualitative risk factors.
In panel C are the uncertainty risks. Risk declarations across my sample relate to increased volatility are categorized as uncertainty risks because they express uncertainty (upside and downside). The statements would include, for example, that the sector is at an early stage of development or that sector demand in cyclical. According to this guideline, five of twenty risk factors are categorized as uncertainty risks. They are technological obsolescence/ rapid technological change, low number of years in
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operation, seasonality, customer dependence, and supplier dependence. Technological obsolescence and rapid technological change maybe let firms’ products quickly out-of-date, and they don’t know how long their products can survive in the market. The worst thing is that the product life is too short to cover costs. The production is unprofitable.
So the uncertainty about market situation will also lead to uncertainty about the future of firms.
Not only technological obsolescence/ rapid technological change but also seasonality will let firms’ profits full of uncertainty. Seasonality lead to unstable income of firms, and this will jeopardize operating of firms, due to unstable earnings and income cash flow. Firms can’t plan their investments in advance, and can’t use their money in the best way. This totally lets firms future full of uncertainty. Besides, firms have low number of years in operation represent that the firms are unmature. The young firms don’t have many operating experiences so whether they can survive in the long time is full of uncertainty.
At last, customer dependence and supplier dependence are also kind of problems.
The more dependence on someone, the less power firms have to negotiate with someone.
Customer dependence and supplier dependence mean the revenues and costs of firms are controlled by third parties. Firms don’t have ability to decide their profit and cash flow, and can’t well arrange their future investment plan, even they have opportunities.
This uncertainty will also jeopardize firms’ survive chance in the future. Due to these reasons described above, I classify those five risk factors as uncertainty risk factors.
In panel C are the downsides risks. Risk declarations across my sample relate to a potential reduction in income/increase in costs might be categorized as downsides risks.
They express solely downside, and would include concerns over, for example, key employees leaving, competition from other businesses and inadequate financing being available for expansion, all of which would be expected to have a negative impact upon revenues. In my classification, half of twenty risk factors meet with the criteria. They are inexperienced management, technical risk, intense competition, legal proceedings against company, liability, manufacturing capacity limitations, need for additional capital, termination of contract, dependence on key employees,and competitive labor markets.
First, inexperienced management, and manufacturing capacity limitations will have bad effects on firms’ operating ability. Inexperienced management might not
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provide good advices to firms and manage firms well. Besides, manufacturing capacity limitations means that firms can’t produce enough products to sell, and they lose potential customers. Even if their products are hot in the market, their profits always fix in there, due to limit quantities of products.
Second, legal proceedings against company, liability, and need for additional capital are the signals that firms are short of money now or in the future. Legal proceedings against company is a risk that if the amount of fine is so big that firms might be bankruptcy. A firm has liability, and need for additional capital represent that they don’t have full cash now. This means that they might lose some potential opportunities to invest in some profitable investment. This is bad for the future of firms.
Third, technical risk, intense competition,and competitive labor markets means that firms are in a competitive environment. The probability of unprofit is high, and the chance of obsolescence products is also big. Fourth, dependence on key employees is also a problem, because this means that they contributed to most of firms’ profits. They might have some excellent abilities, like good experience in this area, the core technology, exclusive patent, and excellent expertise. If they leave, it definitely jeopardize firms future. Even worse, firms might go out of business. At last, termination of contract lets firms lose opportunities to earn money. This is kind of a bad news to firms and investors. Finally, in a word, many situation will harm firms’ profits and these risks are categorizes as downsides risks in my research model.
Table 3-2 Four subgroups of types of risk factors
Panel A：Risk factors related to the financial/non-financial A. Financial1. Legal proceedings against company 2. Liability
3. Need for additional capital B. Non-financial
1. Technological obsolescence/ rapid technological change 2. New product
3. Few or limited products
4. Low number of years in operation 5. Inexperienced management 6. Technical risk
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7. Seasonality
8. Customer dependence 9. Supplier dependence 10. Inexperienced underwriters 11. Intense competition
12. Government regulation
13. Manufacturing capacity limitations
14. Uncertainty regarding patents or proprietary rights 15. Terminationof contract
16. Dependence on key employees 17. Competitive labor markets
Table 3-2 Four subgroups of types of risk factors(continued)
Panel B：Risk factors related to the quantitative/qualitativeA. Quantitative
1. Customer dependence
2. Legal proceedings against company 3. Liability
4. Need for additional capital 5. Dependence on key employees B. Qualitative
1. Technological obsolescence/ rapid technological change 2. New product
3. Few or limited products
4. Low number of years in operation 5. Inexperienced management 6. Technical risk
7. Seasonality
8. Supplier dependence 9. Inexperienced underwriters 10. Intense competition
11. Government regulation
12. Manufacturing capacity limitations
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13. Uncertainty regarding patents or proprietary rights 14. Terminationof contract
15. Competitive labor markets
Table 3-2 Four subgroups of types of risk factors(continued)
Panel C：Risk factors related to the uncertainty1. Technological obsolescence/ rapid technological change 2. Low number of years in operation
3. Seasonality
4. Customer dependence 5. Supplier dependence
Table 3-2 Four subgroups of types of risk factors(continued)
Panel D：Risk factors related to the downsides1. Inexperienced management 2. Technical risk
3. Intense competition
4. Legal proceedings against company 5. Liability
6. Manufacturing capacity limitations 7. Need for additional capital
8. Terminationof contract
9. Dependence on key employees 10. Competitive labor markets
In addition to capturing the quantity of disclosure, this study creates and tests a coding scheme similar to other studies (e.g. Hughesaet al.2001; Cerbioni and Parbonetti 2007; Hali 2002).Coding is the process by which raw data are transformed systematically and aggregated into units, which permit precise description of relevant content characteristics (Holsti 1969). Two researchers who shared the same approaches conduct the coding scheme and code for the content analysis.
In order to consider the content or description of the disclosure, the result of the coding scheme is referred to as a disclosure score. The disclosure score per sample
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company is the summation of per risk factors coded. This study uses a four-class index which attempts to assess the disclosure related to per risk factor presented among 20 items and the four subgroups. Table 3-3 shows the four-class index used in this study.
The results of the content analysis about risk factors from 210 biotech companies contain total items presented in the prospectus, total score summed by per risk factor coded and total words calculated to completely present the content of risk factors. The outcome is listed in the Appendix 2.
Table 3-3 Four-class index
Class Score Description
Quantitative 4 If it provides quantitative information. Or the risk factor is clearly defined in monetary terms or actual physical quantities.
Descriptive 3 If it provides qualitative information specific as toactions, persons, events, or places. Or the impact on the company is clearly evident.
Vague 2 If it is mentioned only generally, not specific.
Immaterial 1 Those disclosures are immaterial to the financial condition and results of the corporation.
This study applies the descriptive statistics to analyze the data from sample companies including five-years profits after IPO, items of risk factors, scores of risk factors and control variables known to affect firms’s long-term performance. The means, medians, first quartiles, third quartiles, and standard errors are calculated and observed to determine whether there is any extreme observation.