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Make Room for a Successful IPO

New high-tech companies are more attractive to investors when they show room for growth.

(originally published by Booz & Company)

Bottom LineHigh-tech companies that go public get better stock market returns when they exhibit organizational slack, or show deficiencies in their operations that signal room for improvement.

In the wake of Facebook’s much-publicized stock market splash and the success of Twitter’s initial public offering (IPO), high-tech firms have again become the darlings of investors. A number of innovative tech companies, including Airbnb, Dropbox, Pinterest, Spotify, and Uber, are expected to go public soon and cash in on their popularity.

According to a new study, if the managers of these companies—and those that seek to follow their example—want to have successful IPOs, they should cut themselves some slack. Or better yet, they should cultivate it. The stock market rewards emerging high-tech firms that possess slack—defined as a marked difference between the company’s available resources and those it’s actually using. The authors posit that evidence of slack is not a sign of inefficiency, but rather a signal to investors that a company has untapped potential.

Combining several databases, the authors analyzed high-tech firms in the United States that went public between 2001 and 2009. These 299 companies operated in a variety of industries, including biotechnology, communications, computer hardware, electronics, medical equipment, and software. Because the study included multiple firms from such disparate high-tech industries, the authors write, the findings can be widely generalized.

The authors assessed the impact of three distinct types of slack. They defined financial slack as a firm’s cash on hand that could have been otherwise spent on equipment, scientists, laboratories, new buildings, salespeople, R&D projects, or improved marketing campaigns. Innovational slack comprised a firm’s unused resources available for the expansion of R&D facilities and staff. And managerial slack was represented by bulk in the number of supervisors, and their accumulated experience in relation to the workload, at the time of the IPO.

After controlling for several factors, the authors found that firms with significant financial slack, especially those with large cash holdings, experienced much higher IPO values. In other words, even though conventional wisdom would hold that savings should be plowed into promising projects, having cash on hand wasn’t seen as wasteful in this circumstance. Instead, investors seemed to view the accumulation of a reserve fund as a sign the company had built the requisite cushion to absorb unexpected hits and to respond to shifts in the economy. “Therefore, in the case of high-tech firms that are planning to undertake an IPO, a solid financial position seems extremely important to reduce the uncertainty surrounding the firm in the eyes of investors,” the authors write.

Slack in innovation also contributed to high-tech firms’ IPO value. Given the cutting-edge nature of their industry, high-tech firms aren’t expected to have their R&D process perfected. Rather, the authors write, “Investors want to see these firms investing more than their peers, which might signal high levels of commitment to innovation.” Investors also valued stronger levels of patent protection, underlining the importance of guarding trade secrets.

High-tech firms aren’t expected to have perfected their R&D process.

Managerial slack played a different role in IPO valuations than the authors predicted. Firms that boasted the requisite number of managers fared moderately. But a firm’s ability to raise funds through an IPO grew with the number of managers and their stature within the company. Although a firm that employs too many supervisors is generally seen as top-heavy, investors appeared to view a surplus of managers as a sign the company was committed to growth, or was laying the groundwork to acquire a larger competitor, the authors found.

Companies must take care, however, that they display the right amount of slack. Moderate slack does a company no good—it signals a lack of purpose and suggests that the company is withholding resources for a larger, but less lucrative, growth initiative than an IPO. Moderate slack amounts to mere window dressing, the authors warn, and investors know the company isn’t worth the gamble.

Source: The Impact of Slack Resources on High-Tech IPOs, Fariss-Terry Mousa (James Madison University) and Richard Reed (Cleveland State University), Entrepreneurship Theory and Practice, Sept. 2013, vol. 37, no. 5


Matt Palmquist

Matt Palmquist is a freelance business journalist based in Oakland, Calif.

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