IPO Pricing and Executive Compensation

ABSTRACT This paper empirically investigates whether executive compensation has any impact on the IPO pricing. Corporate governance issues including the CEO's compensation are critical to the firm at the time of the IPO as many firms establish a formal separation of ownership and control for the first time. Underwriters, financial analysts, and potential investors are involved in pricing of an IPO. Greater levels of ownership by the firm's executives and insiders decrease the underwriters' risk as the new IPO needs price support to be fully placed in the initial offering. Both of these outcomes may decrease underwriters' profits. Initial public offerings present a unique opportunity to study the value that investors assign to executive compensation, because these companies do not have a history of stock prices or publicly available financial information. As such, IPOs block out many of the market forces and media attention that affect their valuations. Through logistic regressions and multiple regressions, we show that if a CEO retains equity ownership in his/her company subsequent to its IPO, this may signal that the IPO price is undervalued based on the anticipated future performance of the company. Thus, both the underwriters and the investors may react differently to the agency implications of equity ownership. The inclusion of other variables, beyond CEO ownership and CEO salary, made the logistic regression model unstable and the coefficients inappropriate. This could be detected from lower significance and lower partial correlations for the variables not in the equation (CEO Options and CEO Bonus). As such, we conclude that the market recognizes the positive signal of the CEO ownership and the CEO salary in IPO pricing in a three-month periods. A correct classification of 85% in the logistic regression also supports the relevance of the CEO ownership and CEO salary in IPO pricing. JEL Classification: G12; G14; G18; G24; G32; K22; M41 Keywords: IPO pricing; Market efficiency; Governance issues; Agency theory I. INTRODUCTION IPO pricing and executive compensation, as separate topics, are among the most widely debated issues both in academe and industry. Despite extensive research in both areas, finance literature is silent as to whether there is a connection between these two important areas. Stated otherwise, "Do investors assign value to executive compensation in pricing an IPO?" This question is the focus of our research. The purpose of our paper is to contribute to a better understanding of a possible relationship between executive compensation and IPO pricing. According to agency theory, a company's managers, including CEOs, will act in ways that satisfy their own self-interests. Therefore, in order to maximize shareholder wealth, it appears that aligning the interest of the CEO and other company executives with those of the shareholders would be beneficial to the company and its profitability. Since there are many types of compensation available to shareholders, it seems there is an incentive for companies to design CEO and other executive's compensation packages that are tailored to the company's needs. The appropriate CEO compensation package for a company may provide incentives for the CEO to work towards the same goals as shareholders and make decisions that will consider both the long-term and short-term effects to the firm. Since companies use a variety of compensation packages, and investors form opinions about each type of compensation, it is reasonable that investors also consider CEOs' compensation structure when determining the value of a company's securities. For actively traded companies that have an established history of public financial information, it may be difficult to determine the value that investors assign to the CEOs' compensation packages. However, initial public offerings (IPO) present a unique opportunity to study the value that investors assign to executive compensation, because these companies do not have a history of stock prices or publicly available financial information. …