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1
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4 ADVANCES IN FINANCIAL
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1 ADVANCES IN FINANCIAL ECONOMICS VOLUME 6

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ADVANCES IN
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ECONOMICS
13 EDITED BY
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16 MARK HIRSCHEY
17 University of Kansas
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2011 KOSE JOHN
21 New York University
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24 ANIL MAKHIJA
25 Ohio State University
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2001
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37 JAI
38 An Imprint of Elsevier Science
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40 Amsterdam – London – New York – Oxford – Paris – Shannon – Tokyo
 iv RUNNING HEAD

1 ELSEVIER SCIENCE B.V.

Sara Burgerhartstraat 25
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First edition 2001
34
35 Library of Congress Cataloging in Publication Data
36 A catalog record from the Library of Congress has been applied for.
37 ISBN: 0-7623-0713-7
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 The paper used in this publication meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of
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40 Printed in The Netherlands.
 Running Head v

1
2
3
4 CONTENTS
5
6
7
8 LIST OF CONTRIBUTORS vii
9
1011 ON THE EXISTENCE OF SUB-STANDARD
11 SECURITY MARKETS: THE IPOs OF BLINDER-ROBINSON
12 James S. Ang and Stewart L. Brown 1
13
14 EXECUTIVE COMPENSATION AND EXECUTIVE
15 CONTRIBUTIONS TO CORPORATE PACS
16 Kathleen A. Farrell, Philip L. Hersch and
17 Jeffry M. Netter 39
18
19
2011 IS MANAGERIAL EQUITY OWNERSHIP AN ALTERNATIVE
21 GOVERNANCE MECHANISM FOR JAPANESE FIRMS?
22 Stephen P. Ferris, Kenneth A. Kim and
23 Pattanaporn Kitsabunnarat 57
24
25 THE INFLUENCE OF MANAGERIAL REPUTATION ON
26 DIVIDEND SMOOTHING
27 Kathleen P. Fuller 83
28
29 THE ROLE OF FEDERAL LAW ENFORCEMENT ACTIONS
3011 IN CORPORATE GOVERNANCE
31 Mark Hirschey and Elaine Jones 117
32
33
34 EMPIRICAL EVIDENCE ON DETERMINANTS OF CAPITAL
35 STRUCTURE
36 Thomas Jandik and Anil K. Makhija 143
37
38 EFFECTS OF HARMFUL ENVIRONMENTAL EVENTS ON
39 REPUTATION OF FIRMS
40 Kari Jones and Paul H. Rubin 161
v
 vi RUNNING HEAD

1 CORPORATE BANKRUPTCY, PRIVATE CREDITORS, AND

2 THE MARKET FOR CORPORATE CONTROL
3 Myron B. Slovin, Marie E. Sushka and
4 Edward R. Waller 183
5
6 THE WEALTH EFFECTS OF BOARD COMPOSITION AND
7 OWNERSHIP STRUCTURE IN INTERNATIONAL ACQUISITIONS
8 Sridhar Sundaram, Indudeep Chhachhi and
9 Stuart Rosenstein 209
1011
11
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14
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 Running Head vii

1
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4 LIST OF CONTRIBUTORS
5
6
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8
9
1011 James S. Ang Barnett Bank Professor of Finance,
11 Florida State University, USA
12
13 Stewart L. Brown Department of Finance,
14 Florida State University, USA
15
16 Indudeep Chhachhi Department of Accounting and
17 Finance, Western Kentucky
18 University, USA
19
2011 Kathleen A. Farrell Department of Finance,
21 University of Nebraska-Lincoln,
22 USA
23
24
Stephen P. Ferris Department of Finance,
25
University of Missouri-Columbia,
26
USA
27
28
29 Kathleen P. Fuller Department of Banking and Finance,
3011 University of Georgia, USA
31
32 Philip L. Hersch Department of Economics,
33 Wichita State University, USA
34
35 Mark Hirschey School of Business,
36 University of Kansas, USA
37
38 Tomas Jandik Sam M. Walton College of Business
39 Administration,
40 University of Arkansas, USA
vii
 viii LIST OF CONTRIBUTORS

1 Elaine Jones College of Business and Economics,

2 Central Missouri State University,
3 USA
4
5 Kari Jones Department of Banking and Finance,
6 University of Georgia, USA
7
8 Kenneth A. Kim School of Business Administration,
9 University of Wisconsin-Milwaukee,
1011 USA
11
12 Pattanaporn Kitsabunnarat School of Business Administration,
13 University of Wisconsin-Milwaukee,
14 USA
15
16 Anil K. Makhija Fisher College of Business,
17 The Ohio State University, USA
18
19 Jeffry Netter Department of Finance,
2011 University of Georgia, USA
21
22 Stuart Rosenstein College of Business Administration,
23 University of Colorado-Boulder, USA
24
25 Paul H. Rubin Department of Economics
26 Emory University, USA
27
28 Myron B. Slovin Department of Finance,
29 Lousiana State University, USA and
3011 HEC School of Management, Paris
31
32 Sridhar Sundaram Emporia State University, USA
33
34 Marie E. Sushka Department of Finance,
35 Arizona State University and
36 HEC School of Management, Paris
37
38 Edward R. Waller Department of Finance,
39 University of Houston-Clear Lake,
40 USA
1
2
3
4 ON THE EXISTENCE OF
5
6 SUB-STANDARD SECURITY
7
8 MARKETS: THE IPOS OF
9
1011 BLINDER-ROBINSON
11
12
13
14 James S. Ang and Stewart L. Brown
15
16
17
18 ABSTRACT
19
2011 In a standard security market, it is assumed that market participants are
21 rational, capable of acquiring and utilizing information, fraudulent and
22 opportunistic behaviors do not pay and are avoided, and transaction costs
23 are relatively low. Furthermore, there is no group of participants who are
24 consistent winners or losers; and collectively, no negative net present value
25 projects are undertaken. We label a market as ‘sub standard’ if most of
26 these conditions do not hold. Theoretically sub-standard markets are
27 predicted to not exist at all, i.e. since even the most sophisticated institu-
28 tional investors with the least transaction and information costs will not
29 participate. This paper presents evidence of the existence of such ‘sub-
3011 standard’ security market over an extended period. Specifically, we present
31 an in-depth analysis of twelve IPOs, underwritten by Blinder-Robinson.
32 The IPOs were offered during a period when Blinder-Robinson was fighting
33 unsuccessfully against NASD sanctions and SEC suspensions. The study
34 is unique in several ways. It is the first detailed investigation of the market
35 for the very small penny stock issues in which the per share offering prices
36
37
38 Advances in Financial Economics, Volume 6, pages 1–38.
Copyright © 2001 by Elsevier Science B.V.
39 All rights of reproduction in any form reserved.
40 ISBN: 0-7623-0713-7

1
 2 JAMES S. ANG AND STEWART L. BROWN

1 of IPOs were at 5¢ or less and the gross IPO proceeds amount to only a
2 few million dollars. We present evidence on the nature of the companies,
3 the background of the executives and the board of directors and the busi-
4 ness and financial characteristics of the IPOs. We also document the
5 differences in the rates of return to various groups involved in the financing
6 or management of these companies: the managers, other insiders, the
7 underwriters and outside investors who invested before, at or after the
8 IPOs. Finally, this study performs an original analysis of the microstruc-
9 ture of the penny stockbroker’s operations by analyzing inside and outside
1011 bid ask quotes. In addition to broker’s markups and markdowns, we have
11 also calculated a measure of the market maker/brokerage house’s incen-
12 tive to its brokers to buy from or sell to their customers.
13
14 1. ON THE EXISTENCE OF SUB-STANDARD SECURITY
15 MARKETS: THE IPOS OF BLINDER-ROBINSON
16
17 Security markets exist to facilitate trading of claims among strangers, to provide
18 liquidity by minimizing transactions and search costs and to enable businesses
19 to raise funds, etc. Underlying the foundations of the models of “standard secu-
2011 rity markets” are implicit assumptions and axiomatic propositions that are held
21 to be generally true. For instance, market participants are expected to be rational
22 and capable of making calculations by acquiring and utilizing information. In
23 addition, it is assumed that market participants do not engage in transactions
24 that are wealth reducing. To enable repeated transactions, some participants
25 who have long horizons value records of previous performance and avoid fraud-
26 ulent and opportunistic behaviors. Transactions occur in the market at relatively
27 low cost because all participants perceive the benefits of trading as exceeding
28 the costs. The expected as well as the realized returns from trading are non-
29 negative. That is, there is no group of participants who are consistent winners
3011 or losers. There are no welfare reducing or negative net present value ventures
31 successfully introduced into the market. And demand for securities does not go
32 up with increases in supply simply because participants are unable to discrim-
33 inate between true value and marketing efforts. When these conditions are not
34 satisfied, the market for securities should theoretically not exist. The “standard”
35 market is widely accepted as a fairly accurate characterization of existing secu-
36 rity markets. Thus, the foundations for standard security markets may only be
37 questioned if security markets violating these requirements are shown to exist.
38 In this paper we present empirical evidence on a security market that seems
39 to have violated the premises of the standard security market. We label it as a
40 sub-standard security market. The sub-standard market in question is the offering
 Sub-Standard Security Markets 3

1 and trading of penny stock shares of IPOs underwritten by Blinder-Robinson.1

2 These securities were initially priced at or under $0.05 (5 cents) per share and
3 the average issue size was in the range of $3–$4 million.2 Transactions costs,
4 as measured by the outside (retail) bid/ask spread, are large. Information acqui-
5 sition and analysis costs are high as these companies have little operating history
6 and provide little data. There are also other implicit costs of trading as the
7 underwriter is also the dominant market maker who sets the price and is often
8 the only source of price quotations and is likely to be on the opposite side of
9 each trade.
1011 Institutional investors, the market participants who are the least handicapped
11 trading in this market due to their lower transaction costs, strong bargaining
12 position vis-à-vis the market maker, lower information acquisition costs and
13 processing ability, do not trade in this market. Thus, in theory this market should
14 not exist. (If the lowest cost participant does not participate, nobody should).
15 And yet, it existed as these IPOs shares were sold to small investors, who had
16 to pay high transaction costs, and made decisions with very little information,
17 and thus, were predicted not to participate in the first place. Furthermore, we
18 present evidence to show:
19 1. Welfare reducing investments were funded i.e. negative NPV IPOs are
2011 offered successfully, on a regular basis.
21 2. Even though the financial characteristics of the IPOs were of extraordinary
22 high risk, the experiences of various groups were quite different. Certain
23 groups of investors in the sub-standard market consistently earned positive
24 returns. Some earned several times the amount of the original investment
25 e.g. corporate insiders, underwriters and first day IPO flippers. On the other
26 hand, other groups of investors consistently lost money i.e. outsiders who
27 purchased shares prior to IPO, at one day after IPO and at post IPO offer-
28 ings suffered heavy, if not complete, loss.
29 3. Marketing efforts on the supply side appeared to affect the amount of a
3011 security demanded. Market-makers such as Blinder-Robinson would change
31 the payoff incentive to brokers in order to increase transactions rather than
32 change the price. Analysis of micro-structure reveals that the daily adjust-
33 ments fell mainly on the inside (wholesale) bid/ask spread, which affected
34 the compensation to brokers, while the outside (retail) bid/ask spread change
35 little, or did not change at all from day to day. Thus, our analysis of market
36 microstructure reveals some unique aspects of the pricing and commission
37 structure of penny stockbrokers. Of particular interest is the way Blinder-
38 Robinson used inside and outside bid ask spreads to direct brokers efforts.
39 We find that there was a much greater incentive given to brokers to have
40 customers buy than to have customers sell.
3
 4 JAMES S. ANG AND STEWART L. BROWN

1 4. Vital informations that could result in an unfavorable valuation of the

2 shares, or might even cause the offering to fail were available, but appar-
3 ently not utilized. For instance, there was adverse information such as
4 pre-offering attempts to beef up the financials, questionable use for the
5 funds raised such as for executive compensation or unspecified or “blind”
6 purposes. Other relevant information that were apparently ignored include
7 a great discrepancy between the estimated value of the issue obtained from
8 the IPO companies own reported financial record and the offering price,
9 and the adverse reputation of the underwriters where record of its serious
1011 legal difficulties with the security regulators, SEC and NASDAQ, that were
11 also disclosed.
12 5. Outside investors also failed to take into account of the very high trans-
13 action costs implicit in the outside bid/ask spread. They are of such
14 magnitude that, for the majority of securities, the prospect of breaking even
15 when purchasing at the post offer first day price and after is practically
16 non-existent.
17
18 2. DATA
19
2011 We were able to obtain complete information of twelve IPOs brought to market
21 by Blinder-Robinson (BR hereafter) in the period from late 1985 through late
22 1988. Information on the companies and financial statements prior to the IPO
23 was obtained from S-18 and other disclosure statements filed with the SEC.
24 Post-IPO financial information was obtained from SEC filings including 8K and
25 10K reports. Price information was obtained from broker quote sheets, pink
26 sheets, the National Stock Summary and related information (10K, Moody’s
27 Industrial Manual). All information used in this paper is obtained from public
28 records.
29
3011 3. RESULTS AND ANALYSIS
31
32
33 3.1 The Characteristics of the Issuing Companies and the IPOs
34
35 Appendix 2 profiles the companies in the sample. The brief history traces the
36 founding of the company, the nature of their business, the IPO and important
37 subsequent events. In general the companies had been recently incorporated, had
38 positive net worth but were not profitable. They represented a wide range of types
39 of business. Three firms were in the food business (two restaurant chains and one
40 distributing company). There was a toy company, a tool company, a finance
 40
39
38
37
36
35
34
33
32
31
3011
29
28
27
26
25
24
23
22
21
2011
19
18
17
16
15
14
13
12
11
1011
9
8
7
6
5
4
3
2
1

Sub-Standard Security Markets

Table 1. Summary Issue Information for the Blinder-Robinson’s IPOs.

The adjusted number of shares offered includes the original number of shares offered as reported in the offering prospectuses, the shares from the
exercise of the underwriter’s (Blinder Robinson) overallotment option, cheap stocks and warrants offered to the underwriters, and shares to be
offered by the existing shareholders. Seafood’s amended registration indicated that the major shareholder/president of the company was registering
an additional 63,420,000 shares. Tele-Art is the only IPO with unit offering. Each unit is consisting of 1 share common stock, 1/5 share ‘A’
warrants at 100% premium over offer price, and 1/5 share of ‘B’ warrant at 200% premium over offer price.
% Share Times Offer
Offer Pre Retained Price Per
Price Original No. Adjusted No. Gross $ of Offer by Pre- Share to
Date of Per of Shares of Shares Proceeds Book Offer Pre-Offer
Issuers Issue Share Offered Offered Raised Equity Shareholders Book Value

1. Allertec 4/4/86 1¢ 120,000,000 142,000,000 $1,420,000 $56,592 61.8% 14.7

5

2. Amereco Environment 4/3/87 5¢ 60,000,000 70,950,000 $3,547,500 $581,935 60.2% 9.3

3. HDL Communications 3/3/87 2¢ 112,500,000 132,187,500 $2,643,750 $230,624 70.0% 14.6
4. Pasta Via 12/6/85 1¢ 150,000,000 187,500,000 $1,875,000 $86,219 57.1% 13.4
5. Paul’s Place 11/12/86 1¢ 170,000,000 203,150,000 $2,031,500 $36,867 65.3% 103.5
6. Seafood Inc. 7/6/87 4¢ 90,000,000 108,000,000 $4,319,200 $533,161 54.2% 13.7
7. Tekna-Tool 12/7/87 5¢ 100,000,000 118,000,000 $4,720,000 $705,574 61.3% 10.5
8. Tele-Art 9/19/86 5¢ 100,000,000 125,000,000 $5,750,000 $2,203,000 57.0% 4.77
9. Thermacor 1/17/86 2¢ 75,000,000 91,250,000 $1,825,000 $88,173 55.2% 25.5
10. Trudy 7/14/87 4¢ 100,000,000 118,065,000 $4,722,600 $1,350,368 63.2% 3.5
11. Western Acceptance 9/17/87 4¢ 62,500,000 70,746,480 $2,829,860 $761,520 50.5% 11.7
Corporation
12. Worldwide Bingo 8/6/86 1¢ 150,000,000 179,625,000 $1,796,250 $153,375 55.3% 14.7

5
 6 JAMES S. ANG AND STEWART L. BROWN

1 company, a vanity press company, a specialty laboratory, an electronics manu-

2 facturer, a company that produced broadcast promotion packages and finally, a
3 company that was developing a line of thermal reduction devices.
4 By 1993, all of the companies in the sample, with one exception, had either
5 filed for bankruptcy, ceased operation and become inactive or had experienced
6 mergers/buyouts which resulted in the original companies ceasing to exist, or
7 even in the same line of business. The one exception is Tele-Art.
8 Table 1 lists the companies and presents summary information concerning the
9 IPO issues. The issues were brought to market with offering periods between
1011 December 1985 and December 1987. Offer prices ranged from one to five cents
11 per share with four issues at one cent, two issues at two cents, three issues at
12 four cents and three issues at five cents.
13 The average number of shares in each issue was in excess of 100 million.
14 Interestingly, this number is as many shares, if not more, than the typical security
15 listed on the New York Stock Exchange. On average there were 10–20% more
16 share actually offered than reported in the original offering prospectus. This extra
17 supply of shares offered came about because of BR’s overallotment (or green-
18 shoe) option, and arrangements to allow BR to buy stock at deep discounts, i.e.
19 cheap stock and warrants, and shares to be offered by the existing shareholders.
2011 On average each IPO had gross proceeds of about $3.1 million with a range
21 of $1.4 to $5.8 million. Thus, our sample is smaller than typically found in studies
22 of small IPO, e.g. Guenther and Willenborg (1999). Interestingly, all of the
23 companies show positive pre-offering book equity, which averages about $0.6
24 million. Thus, on average each offering raised between five and six times its
25 original book value. (a later table will show that a significant portion of the pre-
26 offer equity is due to pre-offering window dressing). In spite of this, the original
27 owners retained the majority (60% on average) of shares and voting rights in the
28 companies. The offering price to the purchasers of the IPO averaged twenty time
29 the pre offer book value per share. The range was from 3.5 times (Trudy) to
3011 103.5 times (Pauls Place). In general Table 1 shows that outside investors paid
31 a rather high premium as measured by the high average offer price to pre-offer-
32 ing book value. Such high valuations associated with unproven small firms could
33 only be warranted if future expected cash flows could justify them. This issue is
34 examined in Table 5.
35 Table 2 profiles the issuing firms in the period before the IPO. The typical
36 (median) firm had been in business only about six months. Firms were generally
37 small with a median number of employees of ten people and were dominated by
38 inside directors.
39 The characteristics and nature of the principals of the firms are often relied
40 upon to highlight the legitimate nature of business enterprise of sample firms.
 Sub-Standard Security Markets 7

1 Table 2. Profile of Issuing Firms Before IPOs.

2
The source of information is the Form S-18, Registration Statement under the Securities Act of
3 1933. Since there are twelve firms in the sample, the median is calculated as the average of the
4 sixth and seventh ranked firms. The number of employees is calculated on basis of full time equiv-
5 alent where part time employment is counted as half full time.
6
7 Median Minimum Maximum
8 1. Months in Business Prior
9 to IPO 6.5 3 111
1011 2. Number of Employees 10 2.5 1,100
11 3. Board of Directors
12 Total 5 2 7
13 Outside 1 0 2
14 4. Auditors (n=12)
15 Majors 6
16 Others 6
17 5. Operating officer’s background (n = 27)
Had responsible position in a major corporation 13
18
Had relevant experience 14
19
6. Officers and director’s who were (n = 57)
2011 graduate of elite private universities 14
21 7. Firms with officers or directors who were related (n = 12) 6
22 8. Firms with Board members associated with venture capital firms 6
23
24
25
26 Half had auditing firms from the major accounting firms and about half of the
27 operating officers had held responsible position in major corporations. About
28 25% of the officers and directors were graduates of elite private universities,
29 and half of the firms had board members associated with venture capital firms
3011 or promoters. However, half of the firms had officers or directors related by
31 blood or marriage to each other.
32 The picture that emerges from Table 2 is somewhat surprising. The issuers
33 appeared to have identifiable products, experienced managers, some with good
34 background, use mostly large auditing firms, and like most IPOs were not prof-
35 itable mainly because they were less established, i.e. younger. Given the legal
36 problems of BR at the time and the general poor repute of penny stock issues
37 and firms,3 the firms and principles in the sample appeared to be of surpris-
38 ingly high quality.
39 Finally, we examine in Table 3 the announced intended use of funds from
40 IPOs. It is of interests that a significant percentage of the funds (36.1%) are
7
 8 JAMES S. ANG AND STEWART L. BROWN

1 Table 3. Proposed Uses of Proceeds from IPOs.

2 The Proceed is Net of Underwriter’s Fees.
3
No. of
4 Uses Firm Mean Min Max
5
6 1. Product and process 5 22.7% 16.3% 34.6%
7 development including
8 fees, review, permit, etc.
9 2. Product promotion: 9 22.3% 1.4% 41%
1011 sales, marketing,
11 advertising
12
13 3. Fixed asset investments 7 33.7% 8.8% 65.3%
14 4. Various fees to 8 3.2% 1.1% 6.1%
15 consultants
16
17 5. Administrative cost 5 23.2% 13.1% 34.4%
18
6. Working capital 9 33.5% 8.2% 51%
19 inventory
2011
21 7. Reduce debt 2 12.5% 2% 23%
22
23 8. Blind e.g. unspecified 6 36.1% 13.6% 58.8%
acquisitions
24
25
26
27
28 designated for unspecified uses such as acquisitions and some are to payoff debt
29 to insiders (average 12.5%) etc. The impact of this coupled with the relatively
3011 lower dollar commitments by insiders would further reduce the quality of the
31 IPO for prospective investors and increase the risk inherent in the investment.
32
33 3.2 Pre-Offering Window Dressing
34
35 One of the reasons for the positive pre-offer book value of the firms in the
36 sample is that there were significant efforts to beef up the book equity of the
37 firms prior to the IPO. Table 4 analyzes the source of pre-offer book equity in
38 the year prior to the IPO. Most of the firms had cumulative deficits prior to
39 the offering and would have had negative equity had it not been for pre-offering
40 maneuvers.
 40
39
38
37
36
35
34
33
32
31
3011
29
28
27
26
25
24
23
22
21
2011
19
18
17
16
15
14
13
12
11
1011
9
8
7
6
5
4
3
2
1

Sub-Standard Security Markets

Table 4. Beefing Up Stockholder’s Equity and Other Pre-Offering Maneuvers: A Summary of Increases in the
Equity Account in the Period 12 Months Prior to IPOs.
Cash contributions from private pre-IPO offering of Equity
Shares in Private Non-cash Increases as % of Book
Private Offer1 Offer Price $ Received Equity: Total
Exchange Other Increase3 Pre-Offer
Issuers Shares in IPO IPO Price Pre-Offer Book Equity Debt for Stock Transactions2 to Equity Stock Splits

1. Allertech 145% 25% 117.3% — 11.4% 11.4% 900:1

2. Amereco — — — 17.1% 3.5% 138% 8,480:1
3. HDL 22.2% 36% 76.5% 124.7% — 201.2% 1,446:1
4. Pasta Via 77.7% 13% 121% 72.3% — 150% 1,102:1
5. Paul’s Place 35% 17% 271% 144% 95% 510% 2,803:1
6. Seafood Inc. 4.7% 66% 17.4% 73.3% 68.6% 159.3% 5,000,000:1
7. Tekna-Tool — — — — — — 185.7:1
8. Tele-Art — — — — — — —
9

9. Thermacor 109% 26% 99% — — — 99%

10. Trudy — — — 27.7% — 27.7% 1,500:1
11. Western
Acceptance 18.3% 66.4% 116.3% 55.7% — 172% 2,822:1
12. World Wide
Bingo 27.8% 17% 30.2% — — 30.2% 6,269:1
Notes: 1. Shares in IPOs include only the number of shares stated in the registration statement. Overallotment options and cheap stock granted
to the underwriters are not included.
2. Examples of other non cash transactions are: (1) Issuer sold stocks to an affiliated company owned by insiders in exchange for a note (loan)
to pay, the effects on the balance sheet are an increase in asset (notes receivable) and in equity; (2) Acquire a bankrupt company in a non
cash transaction by agreeing to assume some debt, possibly at discount. The difference between the book value of the acquired/bankrupt firm
and the assumed debt was recorded as an increase in asset and equity; (3) Issuers sold stock to an outside venture capital firm for cash, whose
amount was equal or less than the contract fee for future consulting service; and, (4) Issued stocks in exchange for services rendered.
3. Issuers with sizable cumulative deficits could show new equity contributions, cash and non-cash, to exceed reported book equity prior
to offering that included these additions.
4. Issuers that did not attempt to beef up equity account had sizeable equity prior to offering; computed as % of net offer proceeds, these
are: Tekna Tool = 17.5%, Tele Art = 56%, Amereco = 21.6%, and Trudy 37.5%.

9
 10 JAMES S. ANG AND STEWART L. BROWN

1 The issuing firms used various ways to pad their book equity. These methods
2 included selling cheap stocks, i.e. at deep discount, debt to stock conversion
3 and some non-cash, perhaps, questionable maneuvers.
4 Without the window dressing to book equity the pre-offering financial situ-
5 ation would have appeared to be even weaker than reported. In particular, the
6 book values reported would be substantially less than those in Table 1, and the
7 IPO offer prices would command even higher premia. The window dressing
8 could contribute to the success of the stock issue offering and increase the
9 amount raised.
1011
11 3.3 A First Look at Ex-Post Results and Some Comparisons
12
13 A way to look at the “reasonableness” in the pricing of these penny stock IPOs
14 is by comparing (i) what IPO investors paid to (ii) estimates of the value of the
15 firms based on cash flows before and after IPOs. Table 5 presents the results of
16 this analysis.
17 The imputed value of the firms (line 1) based on the IPO offer price (gross
18 dollars at offer divided by the fraction of the total shares offered) had a mean
19 value of about $8 million for all twelve firms. The range was from $3.8 million
2011 to $16.8 million. Thus, based on the average, the total imputed value of the
21 twelve firms was about 100 million dollars.
22 Lines 2 and 3 of Table 5 look at the value based on pre-IPO cash flows and
23 lines 4 and 5 look at post-IPO cash flows. Based on the average of the two or
24 three years of cash flows prior to the IPO the average firm value was about half
25 a million dollars (450,000) with a range of 0.7 million to 5.2 million. Based on
26 the average, a very rough estimate of the value of the twelve firms in aggregate
27 is about 5 million dollars or roughly 5% of the value imputed from the offer
28 prices. The corresponding number for the value based on the cash flows in the
29 year prior to the IPO is about $10 million or 10% of the value imputed from the
3011 offer prices.
31 Negative cash flows from operations in the years after the IPO (lines 4 and 5
32 of Table 5) resulted in negative firms values based on cash flows. The average
33 liquidation value of the firms in the sample (exclusive of Tele-Art for which there
34 was no data) based on the last financial statement filed with the SEC. was about
35 0.35 million dollars. Thus, the aggregate liquidation value for the twelve firms
36 was roughly 4 million or 4% of the value imputed from the offer price.
37 It is also of interest to look at the financial results before and after the IPO
38 in somewhat more detail. Table 6 compares sales, expenses, income and cash
39 for two years prior to the IPO, the IPO year and three years post-IPO. Generally,
40 part of the funds raised were used for expansion and thus sales increased.
 Sub-Standard Security Markets 11

1 Table 5. Estimates of Values Based on Cash Flows of Blinder-Robinson’s

2 IPO Firms Before and After IPOs.
3
Mean Min Max
4 (000) (000) (000)
5
6 1. Imputed value based
7 on IPO offer price: $8,269 $3,824 $16,850
Gross $ at offer/fraction
8 of total shares offered
9
2. Average of last 2 or 3 $450 $(771) $5,224
1011 years cash flows prior
11 to offer discounted at 20%
12 3. Cash flows of year prior $785.7 $(743) $7,640
13 to IPO discounted at 20%
14 4. Cash flows from operations (3,690) $(7,235) $263
15 of year after IPO discounted
16 at 20%
17 5. Cash flows from operations1 (2,376) (6,225) (763)
18 over 3 years after IPOs
19 6. Liquidation value, net of $347 0 $2,000
2011 debt, based on the last
21 financial statement filed
22 with SEC (10K. 8K.) or
market value1
23
24 Note:
25 1. These figures do not include Tele-Art.
26
27
28
29
3011 However, expenses, or overhead increased at even faster rate, indicating either
31 window dressing in the pre IPO years to improve income or reduced spending
32 and later increased spending of “other investors” funds after the IPOs, a mani-
33 festations of the typical agency problem. The cash infusion from IPOs, however,
34 did not help the firms to operate profitably. The net effect is that the cash that
35 was brought in via IPOs was dissipated rather quickly and eventually most of
36 the firms in the sample failed.
37 The value of the IPO firms, calculated either from pre- or post-offering cash
38 flows or based on offer prices to the window dressed adjusted book value all
39 indicate serious overpricing of these securities. In the following section we
40 present more direct evidence of the investor’s return.
11
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