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...Securities and Exchange Commission (SEC) Rule 144. The rule regulates the sale of restricted stock by limiting the amount of unregistered stock that can be sold by an individual. We investigate the determinants of post-IPO sales of restricted stock, examine IPO firms' listing choices, and find evidence consistent with firms selecting Nasdaq to reduce the effect of the limits on selling restricted stock imposed by the SEC's Rule 144. Venture capitalists play an important role in this listing decision.
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Most research agrees that firms benefit from listing their stock on the New York Stock Exchange (NYSE). Kadlec and McConnell (1994) and, more recently, Jain and Kim (2006) find that share prices rise when firms move from Nasdaq to the NYSE. Nonetheless, not all firms that are eligible to list on the NYSE choose to do so. Cowan, Carter, Dark, and Singh (1992) report that many Nasdaq firms that qualify to list on the NYSE remain on Nasdaq. Corwin and Harris (2001) show that from 1991 to 1996 more than 20% of the companies that qualified for listing on the NYSE at the time of their initial public offering (IPO), decided to trade on Nasdaq instead.
We examine possible reasons for IPO firms to select Nasdaq over the NYSE, controlling for characteristics of the firm such as its size, the volatility of its common stock, and whether or not it is classified as a high-technology firm. We consider the motives of the founders, venture capitalists, and other pre-IPO investors who choose where the stock will trade after the IPO. We focus on whether some firms choose to list their stock on Nasdaq, rather than on the NYSE, to obtain more advantageous regulatory treatment under Securities and Exchange Commission (SEC) Rule 144, which governs post-IPO sales of restricted stock. Investors who own the stock before the IPO can reduce the effect of Rule 144's restrictions by choosing to have their stock traded on Nasdaq rather than on the NYSE.
We investigate the relation between post-IPO sales of restricted stock and the listing decisions of IPO firms from 1993 through 2000, controlling for the other factors that are relevant to the exchange listing decision. We find that of the 640 IPO firms that are eligible to list on the NYSE from 1993 to 2000, 35% choose instead to list on the Nasdaq, compared to only 23% of the 438 IPO firms eligible for the NYSE that Corwin and Harris (2001) report for 1991-1996. Firms that choose to list on the Nasdaq are smaller than those that opt for the NYSE and are more concentrated in the high-tech sector. Of the firms that choose Nasdaq, 64% have sales of restricted stock during the two-year period following the IPO, compared to only 39.8% of the firms that choose the NYSE. Post-IPO sales of restricted stock are higher for volatile firms, for venture capital (VC)-backed firms, and for firms go public after 1997, but not for firms that sell more secondary shares in the IPO, for firms that went public in hot markets, for firms that have larger post-IPO stock price appreciation, or for firms with greater top management ownership.
When we use logistic regressions to model firms' listing decisions and control for firm size, underwriter quality, and membership in a technology industry, we find that venture capitalists are a major influence behind firms' choice of Nasdaq instead of the NYSE. We also use the number of restricted shares sold during the two years following the IPO as a general proxy for pre-IPO investors selling intentions, and find that post-IPO stock sales are strongly related to the listing decision and are higher for firms that choose Nasdaq. Our interpretation of these results is that venture capitalists and other pre-IPO investors who intend to sell more shares are motivated to choose Nasdaq. This behavior facilitates the later sale of their restricted stock in the firm without their having to undertake an SEO to comply with the provisions of the Securities Act of 1933.
The remainder of the paper proceeds as follows. In Section I, we provide background information on SEC Rule 144. In Section II, we provide information about the data used in our analysis. In Section III, we examine the determinants of restricted stock sales during the two years following the firm's IPO. Section IV reports our findings regarding the listing decision and post-IPO restricted stock sales, and Section V concludes.
I. Background
The Securities Act of 1933 (the Act) requires that all securities being distributed to the public, either by the issuer through an IPO or by an issuer and/or investors through a secondary distribution, be registered with the SEC. Rule 144 exempts certain transactions from this registration requirement. In particular, compliance with the rule provides a safe harbor that permits individual investors who own restricted stock to sell it to public investors. Absent an exemption, all offers or sales of securities to public investors must comply with the registration and disclosure requirements of Section 5 of the Act. t Rule 144 regulates how many shares of restricted stock can be sold within specified periods after an IPO. The underlying rationale for the rule is to enable individuals to conduct day-to-day trading transactions involving unregistered stock, which are permitted under Section 4(1) of the Act, but to prohibit firms and/or investors from making secondary distributions of large amounts of unregistered stock in violation of the Act.
An IPO usually includes only 20% to 30% of the total number of shares that the firm has outstanding. Typical holders of the remaining 70% to 80% of the shares which are unregistered, and are therefore restricted shares, are the firm's early stage investors, including company founders, other employees, venture capitalists, and mezzanine investors. Rule 144 specifies that during any three-month window, the number of restricted shares that can be sold by an individual is limited to the greater of:
1. One percent of the shares outstanding.
2. The average weekly trading volume in the security calculated over the four calendar weeks preceding the week the notice of sale is filed on SEC Form 144.
We refer to these two provisions of Rule 144 as the One Percent Restriction and the Trading Volume Restriction, respectively. Rule 144 also requires that restricted shares be held for a minimum of one year from the time that they were originally acquired. Before 1997, this minimum holding period was two years. We note that when shares have been owned for two years or more, no volume restrictions apply to nonaffiliated persons (essentially, noninsiders) who own restricted shares. Insiders are always subject to volume restrictions.
The provisions of Rule 144 influence the speed with which pre-IPO shareholders can diversify their personal portfolios by selling stock to public investors without registering the shares as part of a secondary equity offering (SEO). Evidence suggests that this limitation is important to shareholders. Kahl, Liu, and Longstaff (2003) find that the economic costs of such liquidity restrictions to the firm's entrepreneurs and other original shareholders can be sizeable. They show that these liquidity costs can be of the same magnitude as those reported in the executive stock options literature. Meulbroek (2001) finds that executive stock options are worth only 53% to 70% of their Black-Scholes value, and Hall and Murphy (2002) report that the value is 40% to 60% of the Black-Scholes value. The post-IPO selling restrictions imposed by Rule 144 are clearly important to pre-IPO shareholders of newly public firms who would like to sell a large number of shares following an IPO, but who wish to do so without using an SEO.
In 1996, the NYSE petitioned the SEC to amend Rule 144 so that its trading volume standard would operate comparably in dealer and auction markets. In a letter dated July 9, 1996, the NYSE stated that "the double counting of trading volume in dealer markets results in a much higher base figure for those markets from which to calculate permitted sales of restricted securities pursuant to Rule 144. This enhanced ability to sell restricted securities listed on dealer markets places auction markets at a competitive disadvantage in attracting new listings." The SEC denied this petition (in a letter dated February 19, 1997), stating, "The Petition provides no evidence to support the alleged anticompetitive effects of dealer market trading volume on the ability of the NYSE to attract new listings."
If enabling pre-IPO investors to diversify their portfolios is an important objective when firms go public, why don't these investors simply sell more of their shares as a part of the IPO itself? Investment banks dissuade pre-IPO investors from selling a material portion of their holdings in the IPO because insider selling in an IPO conveys negative information about the value of the firm (Leland and Pyle, 1977). A recent study by Ang and Brau (2003) underscores the concern about insiders selling stock in IPOs. They find that insiders devise elaborate ways to conceal the extent of their selling in IPOs. Insiders use the widely circulated original prospectus to underreport the number of shares that they plan to sell and later use an obscure amendment to communicate the true number of shares they will sell. Such legerdemain notwithstanding, investment banks frequently dissuade insiders from selling any secondary shares in the IPO to avoid a negative signal, so the act of going public does not per se solve insiders' exit problems.
Lockup agreements, signed with investment bankers at the time of the IPO, also restrict pre-IPO investors from selling shares immediately after an IPO. Such lockup agreements prevent pre-IPO owners from selling shares for a specified period--typically six months--following the IPO, and they generally apply to most of the shares not sold in the IPO. Field and Hanka (2001) examine 1,948 lockup agreements from 1988 through 1997 and find that trading volume increases permanently when lockup agreements expire, with a significant negative abnormal return. Bradley, Jordan, Yi, and Roten (2001) find a similar result for 2,529 lockup expirations from 1988 to 1997, and they also report that the losses are concentrated in firms with VC backing.
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