Determinants of Price Premiums: A Study
of Initial Public Offerings in the Medical
Diagnostics and Devices Industry ^
by Abdul M.A. Rasheed, Deepak K. Datta, and Ravi R. Cbinta
Based on IPOs in tbe medical diag-
nostics and devices industry, tbis study
examined factors tbat influence tbe ex-
tent ofprice premium over book value in
initial public offerings. Findings indicate
tbat wbile tbere are positive relationsbips
between IPO price premiums and tbe
number of uses of proceeds specified in
tbe prospectus, firm leverage and reduc-
Initial Public Offerings (IPOs) repre-
sent a common way by which emerging
firms finance their growth. This is espe-
cially taie when the resources required
for such growth can neither be provided
by the entrepreneurs nor secured
through debt financing due to increased
costs and risks associated with higher lev-
els of debt. The active market for initial
public offerings (IPOs) in recent years
y Dr. Rasheed is currently professor of management at the
University of Texas at Arlington. His research interests are in
the areas of corporate strategy, strategy decision processes,
corporate restructuring, and initial public offerings.
Dr. Datta is currently associate professor of business and
y School of Business Research fellow at the University of Kan-
sas. His research interests include corporate diversification,
mergers and acquisitions, strategic decision processes, and top
management characteristics.
^ Dr. Chinta is currently senior project manager at Senco
Products, Inc. with functional responsibilities in strategic
planning and new business development. He has eight years of
.^experience in the venture capital industry.
*The authors thank three anonymous reviewers for their
valuable suggestions. They also wish to thank Nandini
Rajagopalan, Anthony Daboub, and Li Chin Ho for their valu-
able comments. A previous version of this article was present-
ed at the National Academy of Management Meetings, Dallas,
Texas, 1994.
OCTOBER 1997
tion of management ownersbip bave
negative influences on sucb premiums.
However, no association was found be-
tween tbe premium and underwriter rep-
utation or tbe company's stage of devel-
opment. Implications of" tbe findings and
directions for futura researcb are dis-
cussed. ^
has raised several issues. For example,
initial returns exceeding 200 percent for
IPOs of companies such as Boston
Chicken and Netscape have sparked con-
siderable interest in IPO pricing. Such ex-
traordinarily high returns to investors im-
mediately after the IPO seem to suggest
that in a number of cases IPOs are priced
at a significant premium over their book
value. This leads to the obvious ques-
tions, "Why do some IPOs command a
high premium over book price while
other do not? What factors are responsi-
ble?" These questions have important im-
plications from the perspective of the is-
suer who has a self-interest in maximiz-
ing the share price.
This study addresses the issue of IPO
pricing and investigates the factors that
influence the price premiums in initial
public offerings. Because industry condi-
tions are likely to influence IPO pricing
and price premiums, we control for in-
dustry effects. We focus on IPOs in a sin-
gle industry the medical diagnostics
and devices industry. This industiy has
7
11
been characterized by significant change
and a relatively large number of IPOs,
This article is stmctured as follows. In
the next section, we discuss issues related
to IPO motivations, pricing, and price
premiums. We also discuss the factors
likely to infiuence price premiums and
identify the specific hypotheses exam-
ined in this study. In the next section, we
discuss the research methodology,
including sample identification and selec-
tion, measures, and the analytic tech-
nique adopted. In the final section, we
present the results, discuss the implica-
tions, and suggest possible directions for
future research.
Theoretical Overview and
Research Hypotheses
IPOs: Motivations, Pricing, and Price
Premiums
What motivates the decision to go
public? The literature suggests several
factors, A public offering provides a firm
the resources required to pursue aggres-
sive growth strategies. Since an IPO in-
creases the amount of equity, it also ena-
bles the firm to borrow more. An initial
public offering gives the firm an excellent
opportunity to restructure its balance
sheet. Once the shares are publicly trad-
ed, the firm can acquire new busine,sses
by issuing new stock to the sellers Qames
1989), A public issue also brings greater
name recognition to the company. More-
over, the company may be able to moti-
vate and retain high-quality management
by initiating stock-compensation plans
(Lauer and Zeune 1987),
Besides these benefits to the firm, a
public offering also provides benefits to
the individual owners. First, it provides
the owners a more liquid investment.
Second, it aids in the estate planning of
the firm's principals (Steck 1984), Third, it
is a way to answer the dream of becom-
ing wealthy. The story of Bill Gates be-
coming a billionaire overnight as a result
of Microsoft's IPO is the stuff of legend
(Uttal 1986), In addition, going public
also feeds the desire to become the CEO
of a publicly-traded corporation (Young
and Zaima 1988), At the very least, going
public provides a means for entrepre-
neurs to harvest and venture capitalists tC)
exit from their investments (Timmons
1985),
Overall, an IPO can be viewed as an
event shaped by the motivations, deci-
sions, and actions of three sets of players:
the issuer, the underwriter(s), and the in-
vestors. They are guided by different and,
often confiicting, sets of objectives at the
time of an IPO, For example, issuers like
to maximize the offering price per share
to enhance their returns. In contrast, in-
vestors would like the lowest offering
price, so that they can earn above-market
returns when they subscribe to the issue.
Underwriters, on the other hand, seek to

Table 1
Pricing of IPOs: Players and Motivations
Issuer Underwriter Investor
High price (+) Maximize wealth (+) Maximize income (-) Lower returns
(-) Under subscription (-) Under subscription
(-) Investor alienation
(-) Obligation to meet
underwriting commitments
Low price (-) Ownership transfer (+) Insurance against (+) High returns
at below market legal liability
prices (-) Low commission
income
(+) Low Risk

12 JOURNAL OF SMALL BUSINESS MANAGEMENT

maximize their income from the issue
while reducing potential losses, including
loss of prestige. The motivations of these
three sets of players involved in an II^O
are summarized in Table 1.
If the price is too high, an issue may
remain undersubscribed. Realistically, an
overpriced issue may even fail to find a
willing underwriter. On the other hand, if
the issue is priced too low, the ownership
of the firm is transferred to outsiders at
low prices, penalizing the issuer. In this
case, it is the new investors, instead of the
entrepreneurs and venture capitalists,
who end up realizing high returns. How-
ever, recent theoretical analysis suggests
that under certain circumstances the
owners may underprice an issue to mini-
mize tax liabilities (Dandapani et al.
1992).
On the other hand, underwriters face a
different set of constraints in maximizing
their income from the IPO. Because an
underwriter's income from an issue is
generally a fixed percentage of the per
share price, the undei-writer has an inter-
est in keeping the price as high as possi-
ble. However, if the price is too high, the
issue may be undersubscribed. In such
cases, unclei-writers, who may have made
a firm commitment to the issue at the of-
fer price, face costly alternatives. They
either subscribe to the issue themselves
or sell the shares at a significantly dis-
counted price. Thus, sometimes it may
actually be in the best interest of the un-
dei-writer to keep the issue price relative-
ly low. Tinic (1988) suggests that under-
writers may be motivated to underprice
as a form of insurance against legal liabil-
ity and potential damage to their reputa-
tion. However, empirical evidence since
Tinic's study suggests that law suits are
triggered more by large after-market price
declines than by initial overpricing
(Drake and Vetsuypens 1993).
From the standpoint of investors, IPOs
should be priced as low as possible. This
allows investors to maximize their returns
frotn the investtnent. The price that in-
vestors are willing to pay in an IPO 4s af-
fected by several factors, including; (1)
the amount of information available
OCTOBER 1997
about the stock of a company that is al-
ready listed; (2) the cost that investors in-
cur in collecting information about a new
company (Rock 1986); and (3) the risk of
investing in a company with a litnited or
no track record. For equities of existing
corporations, investors typically have a
wealth of information from sources such
as annual reports, 10-K statements, and
industiy analysts' reports and recommen-
dations. Investors in new issues have
only limited information. In the ca.se of a
cotnpany that has been in existence for
only a very shoit period, the financial in-
fortnation in the prospectus may be inad-
equate for making any meaningful infer-
ences about the firm's future earnings po-
tential. In addition, the products of the
firm may have been in the market for a
very short period or may still be in the
developtnental stage. Thus, the lack of in-
formation about the past and the inability
to make projections about the future
greatly increase the investors' perceived
risk. Understandably, such an investor
expects to be rewarded by an above-nor-
mal rate of return for his willingne.ss to
accept the high risk.
The pricing of initial public offerings
has been the subject of several studies,
primarily in finance and accounting. The
consensus that emerges from these stud-
ies is that IPOs, in general, tend to be un-
detpriced in comparison to the prices that
prevail immediately after the issue (Chalk
and Peavy 1987; Dark and Carter 1993;
Ibbotson 1975; Miller and Reilly 1987; Rit-
ter 1984; Weiss 1988). Similar underpric-
ing has been documented in Canada
(Clarkson and Merkley 1994; Jog and Rid-
ing 1988), as well as in Singapore, Hong
Kong, and Malaysia (Dawson 1987).
Various explanations have been offeted
for such underpricing, some of which will
be examined later in this section.
Price Premiums
Almost all studies on IPOs in finance
and accounting have examined the im-
pact of hypothesized factors on the ex-
tent of underpricing or overpricing, de-
fined as the offering price relative to the
price prevailing in the stock matket itn-
mediately after an IPO. From a manager-
13
 ial perspective, however, there are certain
limitations associated with this stream of
research. First, the owners or the under-
writers can only find out whether the is-
sue was under- or over-priced after a
market price is established through the
trading of securities. In addition, the ex-
tent of under- or over-pricing can vaiy
substantially based on the time period in
which prices are examined. There is
strong evidence that IPO shares trade at
significantly higher prices in the days im-
mediately after the issue date. However,
this result does not hold up if prices over
a longer time period are examined (Eysell
and Kummer 1993). Ritter (1991) found
that the widely documented phenome-
non of underpricing is essentially very
short-nin in nature. If longer time frames
are used, IPOs stocks actually underper-
form those of comparable firms in the
market. Second, recent empirical re-
search indicates that the high prices
prevailing immediately after the issue
date may not necessarily be the result of
underpricing. Aggarwal and Rivoli (1990)
found that this phenomenon may be
more a result of overvaluation or fads in
the after market, since prices declined
substantially in the subsequent period.
Even when high prices may not be attrib-
utable to market fads, they may be the
result of deliberate underwriter price sup-
port. As this support is withdrawn, prices
begin to decline (Ruud 1993). Additional
evidence of overpricing in the early mar-
ket is provided by Schultz and Zaman
(1994). Third, it has been argued that the
initial return (IR) measure widely used in
past literature is ovedy simplistic, as it
overestimates the initial returns available
to the investor and the costs of underpric-
ing to the issuer (McGuinness 1993).
Alternatively, to determine whether a
particular issue is under- or over-priced,
one may look at the pricing decision
strictly in terms of discounted cash flow
analysis (Zent 1990). However, this ap-
proach is often unrealistic, because it is
impossible to determine the future in-
come streams of companies which do not
have a long earnings history or even
commercialized products or services. The
14 JOURNAL OF SMALL BUSINESS MANAGEMENT
only information readily available to all
three players (issuer, investor, and under-
writer) at the time of an IPO is the book
value of the shares as stated in the audit-
ed financial statements of a company. By
focusing on price premium (issue price
over book value) instead of issue price
relative to subsequent market price, this
study emphasizes the entrepreneur's de-
cision making on the basis of available in-
formation, rather than any post-facto
analysis of why the IPO was underpriced.
When going public, issuers typically
expect to get from investors a price per
share that is significantly higher tlian the
book value of the stock. Therefore, it is
not the absolute price at which a share is
issued to the public that is important to
us, but, rather, the premium that investors
are willing to pay over and above the
book value of that share. There is consid-
erable variability in the extent of the pre-
mium. Some IPOs are made at prices
which are several times the book value of
the shares, while others are made at
prices close to book value. This study
focuses on the factors which help explain
this variability.
While the use of book values in the
IPO pricing literature is new (prior
research having almost exclusively
focused on underpricing), there have
been several investigations of the rela-
tionship between the book value and the
market value of firms in the finance and
accounting literatures. For example, Ro-
senberg, Reid, and Lanstein (1985) report
that an investment strategy based on buy-
ing stocks with a high ratio of book value
to stock price produces positive abnor-
mal returns. In addition, Fama and
French (1992) report that book-to-market
equity is a powerful predictor of stock
returns. Moreover, authors such as Ohl-
son (1995) and Feltham and Ohlson
(1995) have also used book value as an
important aspect of their theoretical mod-
els of firm value. Given the increasing at-
tention paid to book value in firm valua-
tion in both tlie theoretical and empirical
literatures, the use of book value of
shares would seem appropriate to the
study of IPOs as well.
Determinants of Price Premiums:
Research Hypotheses
Factors affecting IPO price premiums
can be broadly divided into two cate-
gories. The first set of factors relates to a
potential investor's perceptions of risk.
Generally speaking, investors may be
willing to pay higher premiums for firms
that offer lower levels of risk. This study
examines the relationships between price
premiums ancl four risk-related factors:
debt-equity ratio, undei-writer reputation,
the number of risk factors mentioned in
the prospectus, and the amount of stock
retained by management.
The second set of factors relates to the
costs a potential investor has to incur in
collecting ancl analyzing information
about the issuing firm. Because a relative-
ly young firm going public typically has
neither years of published financial
reports nor the benefit of reporting by
Wall Street analysts, potential IPO in-
vestors have to rely on their own efforts
to collect and analyze information before
making investment decisions. In his infor-
mation-theoretic model of IPO pricing,
Chemmanur (1993) argues that IPOs may
be deliberately underpriced to generate
publicity, hoping to help investors learn
more about the firm. In other words, in-
vestors are induced to engage in informa-
tion production, and, underpricing is the
reward for producing information. In the
following paragraphs, we develop the
specific hypotheses linking factors relat-
ed to both risk and the cost of informa-
tion gathering to price premiums in IPOs.
Leverage. Leverage refers to the financ-
ing provided by creditors relative to the
amount provided by the owners of the
business. The extent of leverage in the
capital staicture is often viewed as a mea-
sure of risk. These risks arise from the fact
that highly leveraged firms may fail to
meet the fixed payments of interest and
principal during periods of declining
sales ancl profits, ancl may be forced into
bankmptcy. Leveraging may benefit a
firm if the firm is able to invest such funds
at a rate in excess of the cost. However, a
highly leveraged firm could suffer consid-
erably if the realized return on its invest-
OCTOBER 1997
ments turns out to be lower than the bor-
rowing rate. Moreover, high leverage can
make earnings more variable (that is,
risky). This is particularly ti\ie in the case
of small ventures, because of the uncer-
tainty regarding the rate of return on in-
vestment. For these reasons, investors
usually prefer a judicious mix of debt ancl
equity, which maximizes the returns on a
per share basis without substantially in-
creasing the level of risk.
The uncertainty and risk that accom-
pany high debt in the capital staicture of
a firm involved in an IPO are likely to
have a negative impact on the price of the
IPO, and therefore on the price premium.
Conversely, IPOs that have a higher com-
ponent of owners' equity are more high-
iy valued by investors. Investors have
greater confidence in such IPOs when
current owners have been willing to risk
their own capital in the venture. This is
likely to be particularly taie in IPOs of
firms with a limited histoiy of sales and
financial performance. These arguments
lead to the first hypothesis examined in
this study.
Hj: The price premium over hook value
in an IPO luill he negatively associated
with the debt equity ratio at the time of
the IPO.
Underwriter Reputation. Several prior
studies have shown that prestigious un-
derwriters price IPOs more fully than
fringe underwriters (Dark ancl Carter
1993; Johnson and Miller 1988; Tinic
1988). Prestigious investment banking
firms avoid underwriting smaller or high-
ly speculative issues (Carter and Manaster
1990; Wolfe, Cooperman, and Ferris
1994). Such issues put the underwriter's
capital and reputation at risk and expose
the undei'writer to subsequent legal
action by dissatisfied investors. Prestig-
ious uncierwriters prefer to sell to in-
vestors who have longer time horizons
(Carter and Dark 1993) and tend to mar-
ket lower-risk IPOs so that investors will
have more confidence in subsequent of-
ferings (Carter 1992). A prestigious in-
vestment banker collects considerable in-
formation about the past and ftiture pros-
pects of the firm before making a com- /
mitment to underwrite an issue. Under- '
15
writers are in a sense certifying the un-
tested management of a young firm,
because of their obligation to "due dili-
gence." The prestige of the underwriter re-
duces uncertainty for investors and elicits
a higher price relative to the book value of
stocks. Thus, we hypothesize that;
Ii2: Tbere will be a positive relationsbip
between underwriter reputation and
tbe price premium at the time of the
IPO.
Stage of development. In this context, a
company's stage of development is based
on whether the firm's products have been
commercially introduced into the market
or not. In many IPOs, the products are
not commercially produced. At times,
they are not even in a developmental
stage. From the perspective of potential
investors, the prospects of a company
whose products have been commercially
introduced are more easily assessed than
those of a company whose products are
still under development. Generally
speaking, the longer a firm has been in
existence, the more likely it is to have a
record of sales. Longevity in a firm, in
turn, reduces information asymmetries
between insiders and potential investors
(Muscarella and Vetsuypens 1989; Young
and Zaima 1988), When market evalua-
tion of the products is absent, the investor
is forced to rely on information provided
by the issuer and the undei-writer. The
risks associated with IPOs of firms whose
products have not been tested in the mar-
ketplace are obviously higher. Conse-
quently, such firms are likely to com-
mand a lower price premium. The inves-
tors expect to pay a lower price for as-
suming greater risks. Therefore, we can
hypothesize that:
H^: Firms ivitb a sales bistory ivill be able
to cbarge bigber premiums tban firms
in tbe development stage.
Number of uses of proceeds. In addi-
tion to risk factors, IPO prospectuses pro-
vide information about the number of
uses of proceeds from the IPO, It can be
argued that such information reduces
both the uncertainty and the information
gathering costs for the investor. However,
the reverse is more likely to be truea
16 JOURNAL OF SMALL BUSINESS MANAGEMENT
high number of uses of proceeds can ac-
tually generate uncertainty among poten-
tial investors, A long list of intended uses
leaves the investor unsure about the
future direction of a firm and the appro-
priateness of the multiple uses of the IPO
proceeds, Beatty and Ritter (1986), for
example, used the number of uses of pro-
ceeds disclosed in the prospectus as a
measure of uncertainty. They found a
positive relationship between the num-
ber of proceeds listed and the degree of
underpricing. It can also be assumed that
the higher the number of the uses of pro-
ceeds, the higher will be the investors'
cost in investigating the potential returns
from them. Consequently, investors will
be less willing to pay a substantial premi-
um for issues with multiple uses. There-
fore, the gap between the IPO price and
the book value will be smaller. This leads
to the fourth hypothesis,
H^: Tbere will be a negative relationsbip
between tbe number of uses of pro-
ceeds and tbe premium tbat a firm is
able to cbarge in an IPO.
Stock retained by management. Al-
though IPOs are a means by which insid-
ers can haivest their investment in the
company, the percentage of ownership
retained by them sends a powerful signal
to potential investors. If the management
and other insiders retain a significant
stake, they communicate a positive out-
look on the future of the firm. The reten-
tion of stock by management as a positive
signal has been demonstrated both theo-
retically and empirically. Grinblatt and
Hwang (1989), for example, propose a
signaling model in which the fraction of
the new issue retained by the issuer con-
veys to investors the intrinsic value of the
firm and the variance of its cash flows.
Gale and Stiglitz (1989) have also demon-
strated theoretically that the sale of equi-
ty in an IPO by insiders is an impoitant
piece of information. In an empirical
study, McBain and Krause (1989) showed
that the offering price in an IPO is rela-
tively high when it appears that the insid-
ers are not "bailing out" as the company
goes public. Similarly, Eysell and Kum-
mer (1993) have shown empirically that
there is an inverse relationship between
initial returns and the proportion of insid-
er shares being offered. It has also been
argued that agency costs may be per-
ceived to be high when insiders sell a sig-
nificant portion of their equity holdings
(Fama and Jensen 1985), The above the-
oretical ancl empirical findings lead us to
the fifth and final hypothesis:
//j,- 'There will be a negative relationship
between extent of reduction in stock
ownership by existing management
and the price premium at the time of
the IPO.
Research Methodology
Sample and Data Collection
Studies in the areas of finance and ac-
counting have typically used large, multi-
industry, heterogeneous samples. How-
ever, this study uses a sample drawn from
a single industrythe medical diagnosis
and devices industry. We decided to limit
the sample to a single industry for two
reasons. First, there has been increasing
awareness in recent years of the need to
control for industry effects in manage-
ment research (Dess, Ireland, and Hitt
1990), Secondly, there is often a signifi-
cant association between industry affilia-
tion and initial returns in IPOs (Ritter
1984), However, this choice did limit the
sample size.
The choice of the medical diagnosis
and devices industry was driven by the
fact that this industry has several interest-
ing characteristics which make it a good
candidate for a single industry study of
IPOs, The industry is highly fragmented
with relatively low average sales per
company and is also characterized by sig-
nificant technological change. This pro-
vides opportunities for many start-ups
and, consequently, a relatively large
number of IPOs (Galant 1992), Typically,
these small companies go through a stage
of being funded by private placements
from venture angels (rich individuals),
followed by venture capital funding, and
eventually IPOs, The industry is charac-
terized simultaneously by prospects for
high profits, as well as significant clown-
OCTOBER 1997
side risk due to regulatory and legal un-
certainties,
A preliminary search using the Invest-
ment Dealers' Digest (IDD) database for
the period 1984-89 (a period of relatively
uniform economic growth) identified 70
IPOs in this industiy; however, missing
values on independent variables reduced
the usable sample size to 57, We consider
the period covered by the study appro-
priate because it does not contain any of
the "hot periods" for new issues docu-
mented in prior studies (Allen and Faul-
haber 1989; Tinic 1988), Thus, the choice
of the time period helped to control for
the impact of macroenvironmental vari-
ables, such as economic growth, which
might influence the pricing of IPOs,
The data used in this study were col-
lected from the prospectuses issued at the
time of the IPO, Corporate prospectuses
have been considered as an excellent
source of valid information for publicly-
held firms (Marino, Castaldi, and Dollin-
ger 1989; Young and Zaima 1988; Pratt
1992),
Variable Operationalization
Underwriter reputation (tJNDREP)
w^s measured as a categorical variable,
with reputable firms being assigned a
value of "1" and less reputable firms a
value of "0," Underwriter reputation was
obtained from the study by Carter ancl
Manaster (1990), which provides a mea-
sure of underwriter prestige based on
tombstone announcements from Invest-
ment Dealer's Digest and the Wall Street
fournal. Support for the validity of this
measure, in comparison to other mea-
sures of underwriter reputation, is pro-
vided by Carter and Dark (1992), Under-
writers with a reputation score greater
than the median score of 5 were classified
as "reputable," Leverage (DEBEQ) was
assessed using the debt/equity ratio
based on the information provided in the
prospectus of each firm. The reduction in
stock ownership by management (MGM-
RED) was calculated as the difference be-
tween the ownership before and after the
IPO, The number of uses of proceeds
(NOUOP) was directly obtained from the
17
prospectus. In many of the prospectuses,
these are listed in a numbered sequence,
minimizing counting problems,' Finally,
the dependent variable, IPO price premi-
um (PRIPREM) was computed as follows:
PIUPREM = (Offering price - Net tangible
book value per share after offering) / Of-
fering price. The measure tells us what
fraction of the offering price represents
the premium over book value. The data
used to calcLilate this measure were taken
from the prospectuses. Stage of develop-
ment (STADEV) was treated as a categor-
ical variable with a value of "0" for com-
panies in the developmental (pre-sales)
stage and "1" for companies that have
commenced sales,^ As is often the case in
IPOs, the products are not commercially
produced at the time of the IPO, As pre-
viously discussed, sometimes they are
not even in a developmental stage.
Data Analysis
Given a continuous dependent vari-
able (PRIPREM), OLS multiple regression
analysis was used to examine Hy-
potheses 1-5, The following model was
utilized:
PRIPREM = (So + IS] (UNDREP) + 13
(DEBEQ) + 1S3(NOUOP)
4 5
where,
PRIPREM = Price premium paid by the
investors in an IPO
UNDREP = Reputation of the under-
writer
NOUOP = Number of uses of pro-
ceeds stated in the pros-
pectus

Table 2
Means, Standard Deviations, and Intercorrelations
of Study Variables
(n = 57)
Variable Mean S.D. 1 i 2 3 4
1, Price premium 0,7 0,09
2, Number of uses 4,49 1,6 0,32' -
of proceeds
3, Leverage 0,21 1,94 -0,24* 0,13
4, Reduction in ownership 15,84 10,69 -0,27' 0,31* 0,31
5, State of development 0,57 0,50 -0,09 -0,07 0,13 0,11
6, Undei-writer reputation 0,33 0,47 -0,05 / -0,16 -0,03 -0,21 0,16
" p < ,001
" p < ,01
' p < .05

' In those cases where the number of uses of proceeds were not numbered, they were counted by
the authors. To avoid errors resulting from subjectivity in counting, two of the three authors did the
counting independently, and the results were compared, tn the three cases where the results differed,
the authors arrived at the final number through discussion and clarification,
^ Ideally, we should have included the sales figure itself, because from the point of view of an
investor, a firm with sales of $10 million is very different from one with sales of only $500,000,
However, the use of the sales figure would have resulted in a very skewed sample given the number
of firms with no sales at all.

18 JOURNAL OF SMALL BUSINESS MANAGEMENT

 Table 3
Results of Regression Analysis: Price Premiums
Variables Estimate r-statistic Tolerance
Leverage -0.011 -3.958*** 0.921
(DEBEQ) (0.003)
Underwriter reputation - 0.014 -0.547 0.916
(UNDREP) (0.025)
Number of uses of 0.025 3.145** 0.847
proceeds (NOUOP) (0.008)
Reduction in ownership - 0.003 -2.386' 0.835
(MGMl^D) (0.001)
Stage of development 0.014 0.651 0.943
(STADEV) (0.023)
Model F-value 6.220"*
Model Ifl 0.379
Model Adjusted ifi 0.318 /
Standard errors are in parentheses.
"> p < .001
" p< .01
p< .05

DEBEQ = Debt/Equity ratio ] sents the unstandardized parameter esti-

MGMRED= Reduction in stocks own- tnates (beta) associated with each of the
ership by management / independent variables, the relevant /-sta-
^STADEV = Stage of developtnent tistic, and its significance level. As indi-
cated in Table 3, the model is significant
Results and Discussion with an 7-statistic of 6.220 (p < .001). The
The means, standard deviations, and tno'clels also explain sigtiificant^variability
the zero-order correlation coefficients in the/price pretiiiutns paid by investors
atnong the variables are provided in iR^ of 0.379 and adjustecl R2 of 0.318).
Table 2. As can be seen from Table 2, (Tests indicate that tnulticollinearity was
there was considerable variability in the dot a probletn.3
price premiutns paid among IPOs in the We had expected the variance in price
sample. Significant variability was also pretniums to be influenced by those fac-
observed in the explanatory variables in tors that increase or decrease the level of
the study. uncertainty in the venture and its value.
The results of the regression analysis Specifically, we had hypothesized that
are ptesented in Table 3. The table pre- the reputation of the underwriter and the

^ Tolerance values were cohiputed for the independent variables in the OLS regressions.
Tolerance is defined as | l-/?i^| >vhere//f,-^ i^ the proportion of an independent variable's variance
explained by the regression model's Other mdependent variables. Although the correlation matrix
indicates a moderate degree of intercorrelation among the predictor variables, tolerance values were
uniformly high (greater than 0.80) suggesting that multicollinearity was not a problem in this study.

OCTOBER 1997
firm's stage of development would be
positively related to the size of ttie price
premium, and that leverage, the number
of uses of funds, and the extent of man-
agement's reduction in stock tiotdings
would be negatively related to the premi-
um. The parameter estimate associated
with leverage (DEBEQ) was significant at
the 0,001 level and negative in sign, pro-
viding strong support to Hypothesis 1, In
addition, the reduction in stoctc owner-
ship by existing management following
the IPO was, as expected, negatively
associated and statistically significant
(p < ,05) with IPO price premiums.
Finally, although the parameter estimate
associated with number of uses of pro-
ceeds was significant at the 0,01 level, it
was in the direction opposite to that hy-
pothesized. Two of the other hypothe-
sized relationships were not significant
(that is, Hypotheses 2 and 3 were not
supported). In other words, the firm's
stage of development and the lead under-
writer's reputation did not have a signifi-
cant impact on the price premiums asso-
ciated with IPOs in the sample.
Study Implications
Our results indicate that the leverage
of the firm, the retention of equity by
management, and number of uses of pro-
ceeds are all significantly related to the
price premium. As hypothesized, higher
levels of debt raise questions regarding a
firm's ability to meet its interest payment
obligations in the post-IPO periocl. The
resulting uncertainty reduces its ability to
command premiums. These findings sug-
gest that it is very important for the issuer
to reduce, to the extent possible, the
component of debt in the capital struc-
ture, A lower debt component reduces
the investors' uncertainty about the firms'
ability to service the debt and become a
viable and profitable entity. In addition,
lower debt and higher owner's equity sig-
nal to potential investors greater commit-
ment and involvement on the part of the
current owners. The relationship be-
tween leverage and price premium was,
therefore, as expected. Similarly, the re-
tention of significant stock by manage-
ment increases a potential investor's con-
20 JOURNAL OF SMALL BUSINESS MANAGEMENT
fidence in the stock, A signal of greater
commitment from the current owners
(those most familiar with the firm) is a
valuable source of information for in-
vestors. Quite likely, investors expect
greater appreciation of shares when in-
siders retain a significant stake in the firm
and investors are therefore willing to pay
a higher premium during the IPO, as indi-
cated by our results.
However, contrary to expectations,
IPOs that listed a greater number of "uses
of proceeds" tended to command higher
price premiums, A possible explanation
for this unexpected finding is that, al-
though a high number of uses of pro-
ceeds increases investors' cost of evalua-
tion, the amount of detail provided by
these uses serves to enhance confidence
in the firm and in the IPO, This higher
level of confidence may lead investors to
pay higher premiums for the IPO, These
results seem to indicate that, for the in-
vestor, the costs associated with evaluat-
ing the alternate uses of the funds are ex-
ceeded by the value of the information.
Surprisingly, our results do not indi-
cate a statistically significant relationship
between underwriter reputation and
price premium. While there are compell-
ing theoretical arguments supporting
such a relationship, no empirical evi-
dence was found in our study. One pos-
sible explanation for these results might
be the often-observed tendency among
"reputable" underwriters to underprice
IPOs to avoid potential damage to their
reputation arising from "overpricing," A
high initial price can reduce post-IPO
returns to investors and can thus trigger
damaging litigation. As Drake and Vet-
suypens (1993) argue, the possibility of
lawsuit and adverse judgement often
causes underwriters to underprice their
offerings.
Directions for Future Research
Our exploratory study, based on 57
IPOs in the medical diagnostics and de-
vices industry, provides interesting in-
sights on factors influencing price premi-
ums. However, its limitations must be
considered in interpreting the results. An
important limitation of the study relates to
4he relatively small sample size. The
study sample was limited to IPOs in a sin-
gle industry, (The rationale underlying
our sample selection has already been
discussed). However, the small size and
single industry do limit the generalizabil-
ity of the findings. To overcome this limi-
tation, future research can extend this
study in mtiltiple ways. For example,
future studies can exatnine whether rela-
tionships identified in this study hold
good for other industries (both manufac-
turing and service). In addition, it would
be interesting to determine whether the
observed relationships hold up in other
time periods as well. Second, additional
insights may be provided by studies
using a "fine-grained" approach, that is,
studies involving qualitative assessment
of the risk factors or the types of uses of
proceeds. Our approach can be des-
cribed as "coarse-grained," in that it used
numerical counts of the number of uses.
Third, alternative operationalizations of
the dependent variable would help in
building more robust models of IPO pric-
ing based on multiple criteria. Some pos-
sible operationalizations would be IPO
price to cunent earnings, IPO price to
gross profits, and IPO price to predicted
earnings. This would also mitigate to
some extent the problems inherent in a
cross-sectional comparison of book
value. The differences in accounting
choices in terms of inventory valuation,
depreciation methods, valuation of
patents and trademarks, etc, make the ac-
counting statements of firms within even
a single industry difficult to compare.
Fourth, the nature of management con-
tracts and other monitoring arrangements
in place (Beatty and Zajac 1994) may sig-
nal to investors information that is valu-
able in deciding whether to invest. There-
fore, it is important to inve,stigate the im-
pact of management contracts on pricing
decisions. Fifth, although this study in-
cluded a measure of leverage, it does not
distinguish between different types of
debt. Recent research findings (Fama
1983; James and Weir 1988; Slovin and
Young 1990) indicate that bank lending is
often a signal of quality, to which the
OCTOBER 1997
market responds positively. The market
perceives bankers as having better judge-
ment about a firm's future viability than
the ordinary investor, because of the
bankers' access to more information.
Sixth, additional variables should be
examined. Examples include the fees
paid to underwriters (Pugel and White
1988), and the revenue growth of the firm
immediately preceding the issue. In con-
clusion, we believe there are significant
opportunities for meaningful research on
the determinants of price premiums in
IPOs, Further studies would complement
this effort and help improve our under-
standing of pricing in IPOs,
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