Venture Capital Valuation, Partial Adjustment, and Underpricing: Behavioral Bias or Information Production?

Date01 May 2015
AuthorJan Jindra,Dima Leshchinskii
Published date01 May 2015
The Financial Review 50 (2015) 173–219
Venture Capital Valuation, Partial
Adjustment, and Underpricing: Behavioral
Bias or Information Production?
Jan Jindra
The U.S. Securities and Exchange Commission
Dima Leshchinskii
Menlo College
Using a sample of venture capital (VC)-backed initial public offerings (IPOs), we analyze
the role played by perceived valuation changes on IPO underpricing. We find that perceived
valuation change from the last pre-IPO VC round to the IPO affects IPO underpricing in a
nonlinear way.Further analysis indicates that information-based theories, not behavioral biases,
explain this nonlinearity.We also find that the previously documented partial adjustment effect
and its nonlinear impact on IPO underpricing are related to the trajectory of the perceived
valuation changes, which stands in stark contrast to prior evidence of the importance of
behavioral biases.
Corresponding author: The U.S. Securities and Exchange Commission, 44 Montgomery Street, San
Francisco, CA 94104; Phone: (650) 489-6807; E-mail:
We thank Wolfgang Bessler, Zhiwu Chen, Douglas Cumming, Jean Helwege, Sophia Johan, Alexander
Ljungqvist, Paul Schultz, Derek Stimel, Robert Van Ness (the editor), Ellie Yin, Jan Zimmerman, two
anonymous referees, and participants at Menlo College Seminar Series, the Academy of Behavioral
Finance and Economics Conference 2011, Midwest Finance Association Annual Meeting 2013, and
Financial Management Association Meeting 2013 for helpful comments and discussions. The Securities
and Exchange Commission, as a matter of policy, disclaims responsibility for any privatepublication or
statement by anyof its employees. The views expressed herein are those of the author and do not necessarily
reflect the views of the Commission or of the author’s colleagues on the staffof the Commission.
C2015 The Eastern Finance Association 173
174 J. Jindra and D. Leshchinskii/The Financial Review 50 (2015) 173–219
Keywords: initial public offering, IPO underpricing, prospect theory, anchoring, asymmetric
JEL Classifications: D82, G02, G24
1. Introduction
There is growing evidence that various corporate decisions are affected by be-
havioral biases.1Specifically, with respect to initial public offering (IPO) research,
Loughran and Ritter (2002) propose that issuers do not get upset about IPO under-
pricing after the offering. This is because the issuers look at the net change in their
wealth and exhibit much less dissatisfaction with share underpricing. Ljungqvist and
Wilhelm (2005) find that managers who experience increases in personal wealth, that
exceed the losses due to IPO underpricing, are less likely to switch underwriters for
a follow-on equity offering. However, research also shows that information coming
to light during the book building process affects the pricing of IPOs in a manner
consistent with theories unrelated to behavioral biases (Hanley, 1993; Cornelli and
Goldreich, 2003; Lowry and Schwert, 2004). Therefore, the relevance of behavioral
biases for IPO pricing remains an important issue. In our research, we compare
the relative importance of behavioral biases and information-based theories on IPO
Two examples illustrate the focus of our study. First, the LinkedIn IPO took
place on May 19, 2011, during a time of otherwise slow IPO activity. Prior to
its IPO, LinkedIn raised money from venture capitalists (VCs) and other strategic
investors in several rounds, giving it valuation of about $2 billion based on the last
round. LinkedIn’s IPO shares were priced at $45 per share, implying a $4 billion
valuation. Its stock price closed at $94.25, more that 109% above its IPO price on the
first day of trading. A second example involves Zymogenetics Inc. which achieved
valuation of $430 million or about $11.70 per common share based on the last pre-
IPO round valuation. About a year later, Zymogenetics filed for IPO with the initial
filing IPO price range of $16 to $18. Five months later, Zymogenetics went public
at $12, a price only slightly above its pre-IPO venture capital (VC) valuation and
well below the initial filing price range. On the first day of trading, Zymogenetics’
shares closed 0.4% above the IPO price. We analyze whether the IPO underpricing
is explained by behavioral biases of the issuer or by information collected during
the book building period. Specifically, is it the irrational anchoring by LinkedIn and
Zymogenetics managers on pre-IPO valuations that led to differing bargaining efforts
1For example, a firm’s52-week high price serves as a reference point for an acquisition premium (Baker,
Pan and Wurgler,2012) and borrowers and lenders when negotiating terms of a new loan anchor on past
loan terms (Dougal, Engelberg, Parsons and VanWesep, 2011).
J. Jindra and D. Leshchinskii/The Financial Review 50 (2015) 173–219 175
and ultimately resulted in dramatically different IPO underpricing for the two firms,
or is it the information collected and observed during the book building period that
had a dominant effect on IPO pricing?
Using a comprehensive sample of firms going public between 1993 and 2013
with available pre-IPO valuations from earlier VC rounds, we calculate the change
in firm value from the time of the VC round to the time of the IPO filing.2We fin d
that firms with valuation increases between the last VC round and the IPO filing have
median IPO underpricing of 20.5% and firms with VC-to-IPO valuation declines
experience median IPO underpricing of only 7.2% (Fig. 1). While this result may
be consistent with predictions based on the prospect theory and anchoring, it may
also be explained by the existing information-based theories of IPO underpricing and
the partial adjustment phenomenon (Hanley, 1993). Specifically, issuers suffering
from behavioral biases anchor on VC valuations, and to the extent that the IPO filing
valuation exceeds the anchor, they do not negotiate aggressively to increase the IPO
price. This would lead to higher underpricing for firms with perceived valuation
increases from VC round to IPO filing. However, during the book building process,
additional information may get incorporated into the IPO price. Therefore, the IPO
underpricing difference may reflect this information production. In particular, to the
extent that the adjustment to the information produced during the book building is
asymmetric as in Hanley (1993), firms for which positive information comes to light
experience higher underpricing than firms for which negative information comes to
Toassess the importance of behavioral biases and information-based theories, we
examine the effect of perceived valuation changes from the last VC round to the IPO
filing and to the actual IPO. Based on the trajectory of the perceived valuationchange,
we identify six unique groups based on the VC, IPO filing, and actual IPO valuations.
While the predictions of behavioral biases and information-based theories coincide
for five of these groups, the predictions of the two theories differ for one group—this
group includes firms whose IPO valuation is above the filing valuation but is still
below their VC valuation. Focusing on this group, behavioralbias theory predicts low
IPO underpricing as the reference point is below the IPO price and induces higher
level of effort from the issuer to set the IPO price higher,t hus reducing underpricing,
while the partial adjustment to the information predicts high IPO underpricing. We
find that IPO underpricing is best explained by information-based theories and not by
behavioral biases. The first contribution of our research is the surprising lack of direct
effect of behavioral biases on IPO underpricing. This result stands in stark contrast
to prior evidence that shows the importance of behavioral biases in other settings that
involve interaction among sophisticated parties.
2We define valuationchange as the percentage difference between the valuation of all firm equity at the
last VC round including preferred stock and at the filing midpoint IPO price, excluding the number of
primary shares issued in the IPO.

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