While the involvement of venture capitalists is widely believed to be beneficial to the future financial performance of high-tech companies going public, that often isn't the case with Internet businesses, according to a new study forthcoming in the Journal of Business Venturing.
"We find that venture capital participation leads to a decrease in the likelihood of profitability and an increase in the time required to move firms into the black," says Narayanan Jayaraman, a professor of finance at Georgia Tech College of Management, who conducted the study with finance professors Bharat A. Jain of Towson University and Omesh Kimi of Georgia State University.
Titled "The Path to Profitability of Internet IPO Firms," their study investigated factors influencing the long-term economic viability of companies going public prior to turning a profit. The researchers examined 160 Internet firms that staged initial public offerings (IPOs) during the dot-com boom of 1996-2000.
While fallout from the dot-com bust required companies to show more maturity and bigger revenues before entering the stock market, recent evidence shows that the number of unprofitable high-tech firms going public is again on the rise. "We believe that our research provides insights that are likely to be useful to investors when similar waves of IPOs and over-investment in emerging industries occur," Jayaraman says. "Such waves of hot and cold IPO markets fueled by the promise of growth rather than profitability tend to repeat over time even for the same industries and sectors of the economy."
Venture capitalists, who contributed to the dot-com boom and bust by infusing too much capital into too many companies with dubious prospects, can detrimentally affect the performance of Internet firms in other ways, Jayaraman says. For example, their ability to cash out early reduces their incentive to effectively monitor management and provide other critical help after the IPO. "Our results do not support recent arguments that venture capitalist involvement provides venture firms with dynamic capabilities that lead to superior post-IPO performance," he says.
In addition to venture capital participation, the researchers discovered other signs that the road to profitability could be long or even a dead end. These include a major drop in the ownership stake of the top three managers, possibly conveying their lack of confidence in the long-term prospects of the firm; a large-sized IPO, because raising too much extra cash can lead to the misuse of funds on unpromising projects; uncertainty about a firm's pre-IPO value; and a large proportion of outside board members.
Though internal control mechanisms are widely perceived to be weak when too many insiders sit on corporate boards, the study notes that early-stage, high-tech firms seem to be an exception to the rule. Outsiders on their boards don't have the detailed knowledge of firm strategy, products, and markets necessary to help steer companies in new and emerging fields, according to the researchers.
"The success of young, high-tech firms is critically dependent on the ideas, entrepreneurial spirit, expertise, and high risk-taking propensity of their founders, top management, and other insiders," Jayaraman explains. He notes that the Sarbanes-Oxley Act has significantly upped the number of outsiders required on boards since the time period examined by the study. "Even if the proportion of insiders has gone down, it's still possible for firms to retain much of their knowledge power. Outside directors can give leeway to insiders as they learn the ropes."
Good indicators of firms' impending profitability are pre-IPO investor demand as well as considerable numbers of employees and years in business. While having a CEO with experience in the technology sector and a CFO previously affiliated with reputable organizations might be expected to shift an Internet company from the red into the black faster, the study didn't find that to be true.
"Our results suggest that the skills and competencies required of top management are fundamentally different in emerging industries such as the Internet, where prior organizational experience in the technology sector or reputable organizations does not convey any significant advantages," Jayaraman says.
For more information, contact Jayaraman at
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