Education decreases the cost of political activity

When most firms go public there is usually a narrower base of investors initially than could be found when examining the ownership of a typical, established US company. Many of the initial investors in a company tend to be insiders, and as many firms mature the percentage of insider ownership within a company often changes. In their paper, Why do Firms Become Widely Held? An Analysis of the Dynamics of Corporate Ownership, Helwege, Pirinsky and Stulz examine how and why many firms evolve into a company that has a widely dispersed group of owners. To do this they examine the dynamics of ownership within a large sample of firms following their IPO’s. Evidence supports that the factors influencing the evolution of a firm’s ownership are the market for the firm’s stock and the firm’s stock performance.

Helwege, Pirinsky and Stulz first explore when it is that firms typically become widely held after their IPO. They examine the ownership of all the firms with IPOs after 1970. They use two measures that signify a firm has become widely held: (1) when insiders own less than 20% of shares, and (2) when insiders own less than 10% of the shares. After 10 years from IPO about half the firms ended up having less than 20% inside ownership, while only about a third of the firms had less than 10%. They were not able to find the point when the majority of the firms had reached an inside ownership level of less than 10% level because when they got to around year 30 there were not enough firms left in the sample for any findings to be significant or credible.

The authors then prepare to explore empirically the reasons for decreasing inside ownership within firms. There are a few existing theories that attempt to explain why insiders decide to reduce their holdings in a company as it matures. Each of the existing theories could be influencing insiders’ actions, but the authors set out to investigate which of the theories best describes the results of their study. The theories include:

1. Moral hazard. There will be a larger fraction of insider ownership when it is easy for insiders to take advantage of outside shareholders. As firms grow, they are better able to control for agency problems, giving insiders less incentive to hold their shares, as they don’t have the same advantages and perks they once had.
2. Adverse selection. When information asymmetries are high, the retention of shares by insiders signals that they believe their shares are worth more than the market is willing to offer. As the public learns more about the company their views will begin to align with the views of insiders. As outsiders are exposed to more of the same information that insiders have, the market will begin to value the stock similarly to what insiders see as a fair value. It is expected that a firm’s ownership will become more dispersed as information asymmetries become fewer and more is made known about a company.
3. Timing. Firms tend to time the sale or issuance of shares, so the shares are advantageously priced at the time of sale or issuance. There is research that shows it is often advantageous for firms to do this. Because insiders make the decisions as to when the firm sells shares, they can also time the sale of their own shares. They also look to sell when there is a deep market for the shares and the demand is more elastic so when a large block of shares is sold there won’t be a large price impact.

The first test conducted attempts to identify factors that lead to significant decreases in insider ownership, defined as a decrease in inside ownership of at least 5%. This change can occur either by the number of insider investors decreasing or the number of outside investors increasing, though the former was found to be more likely. After running multiple regressions the factors that seemed to be strong determinants of decreases in insider ownership were the presence of a deep and liquid market for the stock and when the firm experienced changes in contemporaneous and lagged stock prices. In other words, the stock market variables most greatly influence significant drops in insider ownership. Firms with greater market turnover are more likely to see a fall in insider ownership. Also, firms tend to move to more dispersed ownership when the firm is highly valued in the markets, and a large block of shares can be sold without too much of a discount, indicating a very deep and liquid market for their shares. These variables that influence insider ownership supported the timing theory explained earlier, while variables testing the moral hazard and adverse selection hypotheses were found to be unhelpful in predicting significant decreases in insider ownership.

Next the authors focus on the probability that a firm will become widely held in a year given that it was not widely held the year before. They estimate a hazard model, which estimates the probability of an event occurring while combining multiple periods together in one estimation procedure. Again, they use the 10% and 20% inside ownership level as what defines widely held firm. Helwege et. al find that highly valued firms and high turnover firms are more likely to become widely held in a year when they weren’t the year before. Some variables emphasized by the moral hazard and asymmetric information hypotheses significantly affect this probability. The model predicts that firms are more likely to have less than 10% inside ownership in a given year after never having it before if they:

1. have VC financing,
2. are large,
3. have a low book-to-market ratio,
4. have low cash flow,
5. report R&D expenditures,
6. have low leverage,
7. have low volatility,
8. have high lagged and contemporaneous stock returns,
9. or have high turnover.

All these variables were found to be significant in predicting that a firm will be widely held in a given year, some having a greater impact than others.

The results of both their tests show that the most important factors influencing the evolution of a firm’s ownership are the market for the firm’s stock and the firm’s stock performance. The evidence most strongly supports the hypothesis that insiders sell shares and reduce their holdings when they can do so without putting too much pressure on the stock price by selling shares.