2021 was a record year for initial public offerings (IPOs), with over $155 billion raised in the US alone. Insiders of these firms sold a whopping $35.5 billion in shares in these companies, with many arguing that this indicates a lack of quality in the IPO itself.

A recent study from Texas A&M University looks at the role innovation potential can play in terms of providing a sufficiently credible signal to reduce the impact insider sales have on perceptions of quality.

“Our research, however, documents a positive effect on IPO valuation from informing investors of future innovation plans. It allows managers to reduce information asymmetry, offers background information that helps investors better gauge the impact of insider sales, and ultimately increases the value of the IPO,” the researchers explain.

Credible signals

To explore whether innovation potential can act as a credible signal of a firm’s quality, the researchers tried to document the indirect effect on the valuation of the IPO via the sale of insider shares at the time of the flotation.

“Sales of insider shares have been extensively shown to have a negative effect on IPO performance. We find that firms with higher innovation potential have lower sales of insider shares and when these sales occur, firms incur a relatively lower stock price penalty,” the researchers explain.

They gathered data from 370 IPOs in the pharma and consumer-packaged goods sectors. Both sectors tend to measure innovation potential via things like new product launches, patents, and references to future innovation in the IPO prospectus.

Innovation potential

The researchers admit that some innovation potential proxies are more effective at others in providing a reliable signal of the firm’s overall potential.

“We find that patents have a stronger impact on insider sales than preannouncements and generic references of future innovation,” they explain. “This suggests that insiders appear to put more stock into technological innovation, which perhaps they perceive as more tangible, than in strategic actions or corporate communications that reflect a focus on market-based innovations.”

They believe that their findings will help investors to gain a better understanding of when insider sales might occur as insiders are less likely to sell if they believe the firm has a strong innovation pipeline. It’s more likely that they’ll do so if they’re not optimistic about the future prospects of the firm.

Indeed, a 1% increase in the volume of insider sales suggests that the first-day returns from the IPO will fall by nearly 1% on average. The research has a number of things for managers to consider when they’re taking their firms public.

1. New product preannouncements may be the strongest signal of innovation potential; the total effect of preannouncements on IPO first-day returns is higher than that of patents and generic references of innovation. Investors appear to view it as the clearest indication that the IPO firm will be competitive. Preannouncing an additional new product increases the IPO value by $34.88 million, although in the pharmaceutical industry the value of preannouncements may be driven by the longer life cycle that characterizes products.
2. Should the managers of IPO firms not have a new product that is sufficiently developed, or if they are not comfortable preannouncing it, generic references of future innovation can also grab the attention of both underwriters and retail investors; and the direct positive effect on IPO first-day returns is higher than patents. Communicating the general direction of future innovation plans is itself sufficient to increase the valuation of an IPO firm, although not as much as product preannouncements.