Venture capital, corporate governance, and financial stability of IPO firms

Emerging Markets Review 18 (2014) 19–33

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Venture capital, corporate governance, and financial stability of IPO firms☆ Woody M. Liao a, Chia-Chi Lu b,⁎, Hsuan Wang c a b c

Graduate School of Management, University of California, Riverside, CA, United States Graduate Institute of Accounting and Department of Finance, National Central University, Taiwan College of Management, Yuan Ze University, Taiwan

a r t i c l e

i n f o

Article history: Received 12 July 2012 Received in revised form 29 October 2013 Accepted 6 November 2013 Available online 15 November 2013 JEL classification: G14 G24 G32 Keywords: Corporate governance Excess control Venture capital investments Financial stability Initial public offerings

a b s t r a c t This study investigates the effects of venture capital investments on corporate governance and financial stability of IPO-firms in the emerging markets. We find that VC-backed firms have less agency problems related to excess control than non-VC-backed firms at the time of IPO, and venture capitalists are more likely to improve the excess control problem in firms with weak-governance-structure than those with strong-governance-structure. We also find that VC-backed firms are less likely to encounter financial difficulty than non-VC-backed firms. Taken together, VC investments play a role in mitigating excess control and providing positive financial stability in the emerging markets. © 2013 Published by Elsevier B.V.

1. Introduction Prior research reports that ownership concentration is often found in emerging markets because they have a large number of firms controlled by a small number of controlling shareholders (Claessens et al., 2000; Faccio and Lang, 2002; La Porta et al., 1999). Ownership concentration is normally regarded as an institutional arrangement that facilitates transactions in a weak property rights environment. In such an ownership concentration environment, controlling shareholders have the power and the incentive to negotiate and enforce corporate contracts with various stakeholders. According to Shleifer and Vishny (1997), the benefits for the controlling shareholders are larger in markets that are less developed, or

☆ This research is supported by the Taiwan National Science Council (NSC99-2410-H-008-030). The authors would like to thank seminar participants at the Department of Finance, National Chengchi University, Taiwan. ⁎ Corresponding author at: National Central University, Tao Yuan County 32001, Taiwan. Tel.: +886 3 4267275. E-mail address: [email protected] (C.-C. Lu). 1566-0141/$ – see front matter © 2013 Published by Elsevier B.V. http://dx.doi.org/10.1016/j.ememar.2013.11.002

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where property rights are not well defined or protected by judicial systems. However, concentrated ownership contributes to serious agency problems (Gibson, 2003). Tight ownership control is likely to create an entrenchment problem that allows self-dealings by the controlling shareholders to go unchallenged internally by the board of directors or externally by the takeover market. This entrenchment problem can sometimes come at an expensive price to these firms. For example, prior studies find that, in a weak legal environment with limited protection of minority rights, controlling shareholders can expropriate minority shareholders and create harm to the value of the firm (e.g., Claessens et al., 2002; Lins, 2003; Yeh and Woidtke, 2006). This is so particularly when the controlling shareholders use the pyramidal structures to obtain voting rights in excess of their cash flow rights. This type of agency problem is widely known as “excess control” by controlling shareholders. Given the problem with rising ownership concentration in the emerging markets, a general concern thus arises as to whether there are alternative governance mechanisms available to improve corporate governance and protect minority shareholders. Prior research examining the effects of VC investments on corporate governance documents that venture capitalists can add value to new IPO firms not only in financing but also in improving corporate governance through board compositions, CEO turnover, and monitoring systems (Campbell and Frye, 2009; Hellmann and Puri, 2002; Kaplan and Stromberg, 2003; Lerner, 1995). However, so far little evidence is available regarding the effectiveness of VC investments in mitigating the serious agency problem related to excess control and maintaining financial stability of VC-backed firms after initial public offerings. Therefore, the purpose of this study is first to examine the effect of VC investments on mitigating the agency problem of excess control resulting from ownership concentration in the emerging markets. Furthermore, given the fact that venture capitalists may retain their investments for significant periods of time after the IPO (Barry et al., 1990; Hochberg, 2008), we also investigate whether venture capitalists are effective in ensuring healthy financial stability of their portfolio firms after initial public offerings. In order to empirically examine the effectiveness of VC investments in mitigating the extent of excess control and ensuring healthy financial stability of IPO firms, we focus our analysis on VC investments in IPO firms in Taiwan emerging markets. Taiwanese experience in VC investments offers several advantages as a suitable setting to examine our research questions proposed in this study. First, similar to most emerging markets, Taiwan has a corporate governance environment with weak protection of minority shareholders, high ownership concentration, and predominance of family-controlled firms. Second, we focus our sample selection on the technology-based industry which is similar to the work of Lerner (1994). Lerner analyzes the relationship between venture capitalists and the decision to go public in the biotechnology industry because a homogeneous data sample permits more refinement of comparisons between VC-backed and non-VC-backed firms. In our study, VC investments in Taiwan are widely recognized as a major “technology-oriented” complex in the emerging markets. As presented later in the next section, both total amount and total number of VC investments in the technology-based industry stand at more than 70% of the total investments in Taiwan. Our results in this study show that VC investments significantly mitigate the agency problem of excess control resulting from ownership concentration arrangements in the emerging markets. Furthermore, we find that venture capitalists are more likely to improve the governance problem of excess control in IPO firms with weak governance structure than those with strong governance structure. Finally, we find that IPO firms backed by VC investments are less likely to encounter financial difficulty or distress than those not backed by VC funds for 7 years after public offerings.1 Overall, our results indicate that venture capitalists add value to new IPO firms not only in financing capital needs but also in mitigating the agency problem of excess control. As a result, venture capitalists are able to ensure better corporate governance and healthy financial stability in their portfolio firms after initial public offerings. This paper contributes to the growing literature that examines the important role of venture capitalists in improving the corporate governance and the agency problems of IPO firms in several ways. First, existing venture capital studies are generally focused on the impact of VC investments on the board structure and the corporate governance in IPO firms (Gompers et al., 2005; Kaplan and Stromberg, 2003; Kortum and Lerner, 2000; Lerner, 1999). Little evidence is available regarding the impact of VC investments on the ownership

1

We obtain qualitatively similar results if using 5 years of window after the public offerings for the analysis.

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structure and agency problems in IPO firms. Our study sheds light on the positive effects of venture capitalists on mitigating the agency problem related to excess control. Second, while there is a large body of research addressing corporate governance practices in established firms (see Shleifer and Vishny (1997) for a survey), there have been relatively few studies examining the nature of corporate governance mechanisms in IPO firms. Therefore, our study contributes to the emerging body of literature on corporate governance in IPO firms. Third, our study addresses the impact of venture capitalist on the financial health and stability of IPO firms after public offerings. This extension increases our understanding of venture capitalists' ability to protect their portfolio firms for some time after the IPO. The remainder of this study is organized as follows. Section 2 discusses the development of VC investments and technology firms in Taiwan. Section 3 reviews relevant literature and develops research hypotheses. Section 4 describes research design and sample selection. Section 5 presents empirical results. The final section summarizes our findings and conclusions of the study. 2. Venture capital investments and technology-based industry in Taiwan In the 1980s, Taiwan imported the know-how of VC investing from the US and developed a strategic investment strategy to promote the growth of Taiwan technology-based industry.2 This strategy includes establishing the ground rules for the development of the VC industry3 and investments in technology firms. For almost three decades, the Taiwanese venture capital program and the technology-based industry have been remarkably active and successful. As a result, their VC investments have been highly focused on the development of technology-based firms. Until 1989, the scope of these investments was regulated by the “Regulations Governing Venture Capital Investment Enterprises” and only allowed for developing technology-based firms. Even though the government relaxed the restriction of VC investments in 1989, the majority of their VC investments now still go to the technology-based industry. Up to date, the “big five” industries in Taiwan are semiconductors, electronics, telecommunications, information, and optoelectronics. The number and the amount of VC investments in these industries account for 71% and 72.84% respectively of the current total Taiwanese VC investments. Currently, venture capital investments in Taiwan are notably active as compared to those in other emerging markets. As shown in Table 1, the ranking of VC investments as of GDP is number nine in the world and number four in Asia. Moreover, Taiwan has the most active VC investments in Asia in terms of the number of new start-up firms and successful venture capital investors (Kenney et al., 2004; Megginson, 2004). According to the 2005 Yearbook of Taiwan Venture Capital Association, Taiwan's VC market has raised over NT$180 billion in two decades. Over 400 VC-backed firms have gone public on the Taiwan Stock Exchange (TSE) or Over the Counter (OTC) markets, while nearly 50% of the firms listed on the TSE and OTC were VC-backed and 80% of these firms belong to the technology industry. Although VC funds have invested only NT$170 billion in the technology industry, the investments have created a NT$1.9 trillion industry. These led Taiwan's VC industry to become one of the most active venture capital markets in the world. In fact, due to the government's strategic investment policies, Taiwan technology-based firms have been well-known for their smooth operations and high level of adaptability to changes in business and economic climates. To date, many Taiwanese firms are world-renowned for their excellence in manufacturing 2 Venture capital investments have been widely credited for financing some of the most successful start-up companies in the Silicon Valley and across the US. 3 The mechanisms developed by the Taiwanese government for managing and facilitating the development of the VC industry include:

(1) Regulations in governance: the regulations relating to the operation of Taiwanese venture capital funds are “Regulations Governing Venture Capital Investment Enterprises”, “Scope and Guidelines for Venture Capital Investment Enterprises”, and “Statute for Upgrading Industries”. (2) The government investments: the Executive Yuan Development Fund funneled over NT$8400 million towards some funds since 1983. There are 3 series of this DF investing in VC funds. VC investments in Series 1 started on Sept. 17, 1985; Series 2 started on Feb. 26, 1991; and Series 3 started on Jan. 8, 1998. Four VC funds invested NT$384 million in Series 1. Eight VC funds invested NT $862 million in Series 2. Thirty-nine VC funds invested NT$7215 million in Series 3 (up to 2005). (Source: Development Fund website: http://www.df.gov.tw/ (mdkknt4524s0l245lx3ol3vv)/dfgov-index.aspx.) (3) Incentive for private investors to invest in the VC funds: the government provided a 20% income tax credit to individuals and corporations holding shares in venture funds (available after a two-year vesting period) until May 2001. This tax deduction was repealed in December 1999 by the 8th amendment of the “Statute for Upgrading Industries”.

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Table 1 Venture capital fund-raising and investments by country, year 2000. Rank

Country

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

United States United Kingdom France Germany Canada Israel Italy Hong Kong SAR Sweden Japan Netherlands Singapore Taiwan Spain Korea Argentina Australia Switzerland India Belgium World total

Funds raised, year 2000

Investment value, year 2000

Gross domestic product

Venture capital investments

(US$ billions)

(US$ billions)

(US$ billions)

As % of GDP

Ranking

$153.9 16.3 6.9 5.7 2.8 3.3 2.7 5.8 3.4 4.5 2.6 2.0 1.1 1.8 1.6 NA 0.8 0.9 0.8 0.8 $225.0

$122.1 12.2 4.9 4.4 4.3 3.2 2.8 2.2 2.1 2.0 1.8 1.2 1.2 1.0 1.0 0.9 0.7 0.6 0.5 0.5 $177.0

$9152 1442 1432 2112 635 101 1171 159 239 4347 394 85 310 596 407 283 404 259 447 248 $24,223

1.33 0.85 0.34 0.21 0.68 3.17 0.24 1.38 0.88 0.05 0.46 1.41 0.39 0.17 0.25 0.32 0.17 0.23 0.11 0.20

4 6 10 15 7 1 13 3 5 20 8 2 9 18 12 11 17 14 19 16

Sources from Price Waterhouse Coopers, Global Private Equity 2001 (Palo Alto, CA: September 2001) [www.pwcmoneytree.com], GDP data, and World Bank Group [www.worldbank.org/data/wdi2001/pdfs/tab4_2.pdf]. The data for Taiwan came from the Institute for International Management World Competitiveness Yearbook 2001 [www.imd.ch/wcy/criteria/1101.cfm].

technology, making them the world's second largest producers of information and communication hardware. Consequently, the share of global market held by Taiwanese manufacturers exceeds 70% for several key technology products, such as notebook PCs, wireless local area network (WLAN) equipment, liquid crystal display (LCD) products, and optical disk drive (ODD) products. According to the report on “Global Competitiveness in 2006–2007” issued by the World Economic Forum (WEF), Taiwan ranks sixth in the world in terms of the Growth Competitiveness Index. In addition, Taiwan ranks second in the world after the US in terms of international patents per capita. In fact, Taiwan is the only country in East Asia that has closed the innovation gap with leading Western industrial nations and Japan (Breznitz, 2005). 3. Relevant literature and development of hypotheses This study investigates three issues regarding the effects of VC investments on the agency problem related to excess control and financial stability of IPO firms after public offerings. In this section, we review the literature on the agency problem related to excess control and discuss the effects of venture capital investments on the governance structure of IPO firms. After that, we develop research hypotheses to test whether VC investments add value to IPO firms by mitigating excess control and ensuring financial stability after public offerings. According to La Porta et al. (1999), when ownership is sufficiently concentrated, the controlling shareholders are able to control the profit distribution and sometimes deprive minority shareholders of their rights to share profits. Furthermore, this agency problem can be exacerbated when the controlling shareholders leverage their control through stock pyramids or cross-shareholdings. Following this ultimate control concept, we analyze the level of excess control by controlling shareholders as a proxy for the agency problem of ownership concentration in the emerging markets. In this case, excess control by controlling shareholders is determined by their voting rights in excess of their cash flow rights. It is important to note that, while the voting rights measure the degree of control, the cash flow rights measure the degree of ownership. Thus, the deviation between ownership rights and control rights delineates the

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controlling shareholders' incentive and hence the firm's agency problem. The higher the voting rights of the controlling shareholders, the more entrenched is their position, and thus the more they are able to expropriate wealth from minority shareholders. On the other hand, the higher the cash flow rights of the controlling shareholders, the higher the cost they bear to expropriate, and thus the more their interests are aligned with the minority shareholders. Therefore, as the level of excess control relative to the level of ownership increases, the controlling shareholders become more entrenched, and their incentives to expropriate minority shareholders increase. The vital role of venture capitalists in the promotion of new public firms is well documented in the literature (Barry et al., 1990; Lerner, 1994; Megginson and Weiss, 1991). Venture capitalists are professional and experienced investors in capital markets. They provide equity financing to new IPO firms where their primary return is eventual capital gains and dividend yields (Wright and Robbie, 1998). As shareholders of new IPO firms, venture capitalists are likely to face agency risks due to information asymmetry caused by (1) operating at the earlier development stage of the new firms, (2) the technological innovation sought by the new firms (Manigart and Sapienza, 2000), and (3) a more long-term investment horizon of between 5 and 7 years (Gorman and Sahlman, 1989; Van den Berghe and Levrau, 2002). In order to reduce information asymmetry and increase their investment returns, venture capitalists often contract to participate in various activities of the new firms through their screening, monitoring, and decision-support functions. Typically, venture capitalists use their knowledge, expertise, and contacts to assist the new firms in developing strategic and financial planning and controls (Barry, 1994; Gorman and Sahlman, 1989; MacMillan et al., 1989; Wright and Robbie, 1998). These activities, in addition to the infusion of capital, are critical to ensure that a steady stream of well-prepared firms goes public. Both theoretical and empirical research consistently support the general expectation that venture capitalists are value-added investors and take an active role in developing their portfolio firms (e.g., Gompers et al., 2005; Kaplan and Stromberg, 2003; Kortum and Lerner, 2000; Lerner, 1999). An additional benefit of venture capitalists is their contribution to improve the corporate governance practices of the new IPO firms. Rosenstein (1988) first explores the improvement in the board of directors of VC-backed firms. He observes that the boards consist of more outsiders and some of them have a higher degree of expertise in the new IPO firms. Furthermore, he finds that board meetings frequently revise strategic issues. Baker and Gompers (2003) also examine the determinants of board structures and the effects of the board structures on the success of the new IPO firms. They find that venture capitalists shaft the composition of the board of directors of the IPO firms away from insiders and gray directors and the resulting board structure is more of a compromise between the insiders and the outside investors. Recently, Boone et al. (2007); Campbell and Frye (2009), and Suchard (2009) also find similar results to those of Baker and Gompers (2003) in the improvement of the board structure of VC-backed IPO firms. Given the success of venture capitalists in improving the board structure of the IPO firms, a related question that may be asked is whether VC investments mitigate the agency problem related to excess control in the emerging markets. So far, little evidence is available with respect to the effectiveness of VC investments in mitigating the agency problem related to excess control. We develop the following hypotheses to empirically test the effects of VC investments on mitigating excess control by controlling shareholders. Hypothesis 1. IPO firms backed by VC investments have less excess control by controlling shareholders than those not backed by VC investments at the time of IPO. VC investments in IPO firms may include some with weak corporate governance and others with strong corporate governance. Regardless of the type of IPO firms, venture capitalists are expected to concentrate on strengthening the advantages and alleviating the weaknesses of these firms in order to increase the value of their portfolio investments. As a result, the governing effect of venture capitalists on mitigating excess control is likely to be greater in VC-backed firms with weak governance than those with strong governance. Therefore, we develop our second hypothesis below to test this different governing effect of venture capitalists on excess control by controlling shareholders in IPO firms. Hypothesis 2. The governing effect of venture capitalists on mitigating excess control is greater in IPO firms with weak corporate governance than those with strong corporate governance.

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Our final hypothesis is to examine the effect of the involvement of VC investments on financial stability of IPO firms following their public offerings. Prior research documents that venture capitalists play an important role in financing and monitoring activities and thus add values in VC-backed IPO firms. Furthermore, it is reasonable to expect that VC-backed IPO firms are less likely to report the reversal of earning management because venture capitalists often restrain IPO earning management (Ahmad-Zaluki et al., 2009). As a result, these IPO firms are more likely to experience stable and healthy financial prospects than non-VC-backed firms (e.g., Baker and Gompers, 2003; Jain and Kini, 2000; Suchard, 2009). Therefore, we expect that VC-backed IPO firms encounter less financial difficulty or distress than non-VC-backed IPO firms after public offerings. Accordingly, we develop the following hypothesis to test the difference in financial stability between VC-backed and non-VC-backed IPO firms after the IPO. Hypothesis 3. VC-backed IPO firms encounter less financial difficulty or distress than non-VC-backed IPO firms after their initial public offerings. 4. Research design 4.1. Sample selection Our sample firms are technology-based IPO firms listed on the Taiwan Stock Exchange (TSE) and the Over the Counter (OTC) markets. These new IPOs were issued during 1996 and 2001. The reason for selecting this sample period is that, in Taiwan, the ownership structure data were only available starting from 1996 and also we would like to track a seven-year financial stability of the sample IPO firms after the IPO. All financial data up to 2008 are collected from the database of the Taiwan Economic Journal (TEJ). In addition, we identify and collect VC investment data from the 2002 Yearbook of the Taiwan Venture Capital Association (TVCA). We delete those firms that have missing financial data during the sample period or have their fiscal year not ending on December 31. Our final sample consists of 223 IPO firms, which include 127 VC-backed firms and 96 non-VC-backed firms. 4.2. Regression models Our first hypothesis predicts that IPO firms backed by VC investments have less excess control by controlling shareholders than those not backed by VC investments at the time of IPO. To test this hypothesis, we use the following pooled cross-sectional regression model: EXCESS
CONTROLjt ¼ a0 þ a1 VCjt þ a2 OWNERSHIPjt þ a3 AGEjt þ a4 SIZEjt þa5 FAMILYjt þ a6 CEOCHAIRjt þ a7 AUDITjt þ εjt

ð1Þ

where, for sample firm j at IPO time t, the predicted sign of a1is negative, and EXCESS_CONTROLjt Corporate agency problems related to excess control which is measured in two ways: (1) controlling shareholders' voting rights minus their cash flow rights, VOTING-OWNERSHIPjt, and (2) the ratio of the controlling shareholders' voting rights to their cash flow rights, VOTING/ OWNERSHIPjt; VCjt An indicator variable taking the value one if the firm at time t is a VC-backed firm and zero otherwise; OWNERSHIPjt The percentage of the cash flow (ownership) rights owned by the controlling shareholders; AGEjt Age of the firm; SIZEjt The natural logarithm of the firm total assets; FAMILYjt An indicator variable taking the value one if the firm is a family-controlled firm and zero otherwise; a firm is defined as a family-controlled firm if the controlling family controls at least 20% of a firm's control rights (e.g., Claessens et al., 2000; Faccio and Lang, 2002; La Porta et al., 1999; Yeh and Woidtke, 2006);

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CEOCHAIRjt An indicator variable taking the value one if the CEO also serves as the chair of the board and zero otherwise; AUDITjt An indicator variable taking the value one if the firm is audited by a Big-5 auditor and zero otherwise; εjt Error term. Hypothesis 2 examines different governing effects of venture capitalists on mitigating excess control between IPO firms with strong and weak corporate governance. Since venture capitalists are experienced investors with expertise knowledge in the IPO firms, they are more likely to mitigate the excess control problem in those firms with weak governance than those with strong governance. To test this hypothesis, we run the pooled cross-sectional regression model again for each of two subsample groups (those with strong governance and those with weak governance). Our partition of the subsample groups is based on two criteria: OWNERSHIP and CONTROLBOARD. First, OWNERSHIP measures the percentage of cash flow rights owned by the controlling shareholders. When this percentage is large, the controlling shareholders' interest is largely tied to the performance of the firm. In this case, their incentives are more aligned with that of the minority shareholders. Consequently, we expect corporate governance to be strong (weak) if OWNERSHIP is large (small). On the other hand, the second criterion measures the percentage of the controlling shareholders sitting on the board, CONTROLBOARD. Yeh and Woidtke (2006) study whether a firm's board structure is indicative of the quality of its corporate governance. They report evidence that, when the majority of directors are related to the controlling shareholders, an agency conflict is likely to occur between the controlling and the minority shareholders and thus create weak corporate governance. Therefore, we consider corporate governance to be strong (weak) if CONTROLBOARD is small (large). As a result, IPO firms with strong (weak) governance are referred to as those with OWNERSHIP greater (less) than the median or CONTROLBOARD less (greater) than 50%. In Hypothesis 2, the predicted sign of a1 is more negative for VC-backed IPO firms with weak governance than those with strong governance. In Hypothesis 3, we examine the relation between venture capital investments and financial stability of IPO firms after public offerings. In this study, we measure financial stability in terms of the degree of financial distress or difficulty in the IPO firms after public offerings. Taiwan Economic Journal (TEJ) maintains an annual database on Taiwanese security markets. This database provides detailed corporate information about all listed firms in the Taiwan Stock Exchange and the Over the Counter markets. For example, nine event types are reported by TEJ as indicators for having financial distress or difficulty in a firm: (1) bounced checks or bank runs, (2) business closure or bankruptcy, (3) criticism of CPA and skepticism of continuous operation, (4) restructuring, (5) requesting financial aid and rescue, (6) takeover, (7) full-cash-deliver delist, (8) plant shutdown, and (9) negative book value. In this study, we consider a firm having healthy financial stability if it is not reported as having encountered any one of the nine events by TEJ over a seven-year period after public offerings. Similar to Baker and Gompers (2003), we collect our financial stability data for each IPO firm over a period of 7 years after the public offering. We use both the probit and the logit regressions to analyze the relationship between financial stability and VC-backing for a seven-year period after public offerings. Since larger, less risky, and better performing firms may be more likely to receive VC financing, we address the issue of endogeneity in the next section. In addition, we include ownership and other firm characteristics as control variables along with VC-backing in our probit and logit regression analyses as follows: PROBLEM j;tþ7 ¼ b0 þ b1 VCjt þ b2 OWNERSHIPjt þ b3 VOTINGjt þ b4 SIZEjt þ b5 LEV þ b6 PROFITjt þb7 AGE þ εjt

ð2Þ

where, for sample firm j at IPO time t, the predicted sign of b1 is negative, and PROBLEMj,t + 7 An indicator variable taking the value one if a firm at or before year t + 7 had financial distress or difficulty per the TEJ database, and zero otherwise; VCjt An indicator variable taking the value one if the firm at time t is a VC-backed firm and zero otherwise; OWNERSHIPjt The percentage of the cash flow (ownership) rights owned by the controlling shareholders; VOTINGjt The percentage of the voting rights controlled by the controlling shareholders;

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LEVjt PROFITjt AGEjt

The firm's leverage ratio at the beginning of the fiscal year, calculated by one minus the ratio of book value of equity to total assets of the firm at the beginning of the fiscal year; Ordinary income deflated by total assets of the firm at the beginning of the fiscal year; Age of the firm.

4.3. Treatment for endogenous choice of VC investments It is possible that firm characteristics may essentially determine who receives the VC financing in the Taiwan technology-based industry. In this case, an endogeneity problem may arise because of self-selection or VC investments in better performance firms. In order to address this endogenous issue, we design a selection framework similar to Heckman (1979) to control for endogeneity in the VC investment decisions. As a result, our regression model is a two-stage estimation model. In the first-stage equation estimation, VC is the dependent variable (an indicator variable taking a value of 1 if the firm is a VC-backed firm and 0 otherwise). The independent variables are LEV, PROFIT, INVESTMENT, and RD. So, we perform first-stage regressions based on the following model: VC j;tþ7 ¼ c0 þ c1 LEVjt þ c2 PROFITjt þ c3 INVESTMENTjt þ c4 RDjt þ εjt :

ð3Þ

In this probit model, LEV = Debt/Assets measures the solvency of a company. We expect the Debt/ Assets ratio to be substantially different between the two sub-sample groups because VC-backed firms have greater financing needs than non-VC-backed firms. PROFIT = Profit/Assets measures the profitability of a firm. Again, because of their greater financing needs, we expect VC-backed firms to have lower profitability ratio than non-VC backed firms. INVESTMENT = Investment/Assets measures the capital investment profile of a firm. We consider this as an independent variable because anecdotal evidence suggests that VC-backed firms typically have a higher investment rate compared to non-VC-backed firms. Finally, RD measures R&D intensity of a firm. Given that firms with higher R&D intensity have more innovations, we expect R&D intensity to be substantially different between the two sub-sample groups. As a result, we obtain a Lambda for the error term from the first-stage probit model estimation. The Lambda derived from the first-stage model estimation is then added into the second-stage regression analysis to control for the endogeneity problem. Therefore, in the second stage model estimation, our variable of interest (excess control or financial stability) is treated as the dependent variable and a number of selected control variables in addition to VC and the Lambda are considered as the independent variables. 5. Results 5.1. Summary statistics This study collected a number of technology-based IPO firms listed on the Taiwan Stock Exchange (TSE) and the Over the Counter (OTC) markets, and were issued during 1996 and 2001. Collection of the sample was started from 1996 onwards, because the variables regarding ownership structure were only available starting from that year. The sample collection was ended in 2001, since we would like to track a seven-year performance of these sample firms after they go public. This time period yields a sample of 223 technology-based IPO firms. Table 2 reports the distribution of the sample firms by year. As shown, there are approximately 57% of technology-based IPO firms backed by venture capitalists, suggesting that venture capital backing plays a significant role in facilitating the process of IPOs in Taiwan. Except for 1997, the number of total IPO firms is increasing every year during the sample period. However, the percentage of VC-backed firms is going down between 1996 and 1999, and then slightly going up between 1999 and 2001. This trend is consistent with the performance of Taiwan stock markets in this period. This finding is also consistent with the documentation of prior studies showing that venture capitalists are professional investors in the IPO capital market and VC-backed firms often find a better timing to go public.

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Table 2 Taiwanese technology-based IPO firms (1996–2001). Non-VC-backed

VC-backed

Total firms

IPO year

N

N

N

%

1996 1997 1998 1999 2000 2001 Total

6 4 13 23 28 22 96

14 10 22 15 29 37 127

20 14 35 38 57 59 223

70.00 71.42 62.86 39.47 50.88 62.71 56.95

Percentage of VC-backed IPOs

5.2. Empirical results of VC on corporate governance We first compute the t-statistics to test for the difference in the means of each variable for VC-backed firms and non-VC-backed firms. Table 3 reports the results of the mean tests. As shown, OWNERSHIP, VOTING, CONTROLBOARD, AGE, PROBLEM, and LEV in VC-backed firms are significantly lower than those in non-VC-backed firms at a less than 10% level, while SIZE in VC-backed firms is significantly higher than that in non-VC-backed firms at a less than 10% level. These results indicate that firms backed by VC funds have the following characteristics: smaller ownership rights (OWNERSHIP), smaller voting rights (VOTING), larger size (SIZE), younger age (AGE), less likely to have financial distress or difficulty (PROBLEM), and lower debt to asset ratio (LEV). Next, we provide multiple regression analyses to test our three hypotheses. In Hypothesis 1, we test whether IPO firms backed by VC investments have less excess control than those not backed by VC investments. Table 4 presents the results of regressing EXCESS_CONTROL, proxied by two different Table 3 Mean test results.

VOTING-OWNERSHIP VOTING/OWNERSHIP OWNERSHIP VOTING CONTROLBOARD CEOCHAIR FAMILY SIZE AGE AUDIT PROBLEM LEV PROFIT

Non-VC-backed (N = 96)

VC-backed (N = 127)

Mean

Mean

0.07 2.32 29.29 36.21 0.63 0.39 0.36 14.30 15.05 0.86 0.18 0.41 0.09

0.08 3.06 22.12 29.65 0.56 0.35 0.30 14.78 11.83 0.91 0.10 0.38 0.09

t value for difference in means

−0.41 −0.90 3.11*** 3.00*** 2.77** 0.47 1.03 −3.36*** 3.39*** −1.16 1.69* 1.69* −0.74

VOTING-OWNERSHIP: controlling shareholders' voting rights minus their cash flow rights; VOTING/OWNERSHIP: the ratio of the controlling shareholders' voting rights to their cash flow rights; OWNERSHIP: the percentage of the cash flow (ownership) rights owned by the controlling shareholders; VOTING: the percentage of the voting rights controlled by the controlling shareholders; CONTROLBOARD: the percentage of the controlling shareholders sitting on the board; AGE: age of the firm; SIZE: the natural logarithm of the firm total assets; FAMILY: an indicator variable taking the value one if the firm is a family-controlled firm and zero otherwise; a firm is defined as a family-controlled firm if the controlling family controls at least 20% of a firm's control rights (e.g., Claessens et al., 2000; Faccio and Lang, 2002; La Porta et al., 1999; Yeh and Woidtke, 2006); CEOCHAIR: an indicator variable taking the value one if the CEO also serves as the chair of the board and zero otherwise; AUDIT: an indicator variable taking the value one if the firm is audited by a Big-5 auditor and zero otherwise; PROBLEM: an indicator variable taking the value one if a firm at or before year t + 7 had financial distress or difficulty per the TEJ database, and zero otherwise; LEV: the firm's leverage ratio at the beginning of the fiscal year, calculated by one minus the ratio of book value of equity to total assets of the firm at the beginning of the fiscal year; PROFIT: ordinary income deflated by total assets of the firm at the beginning of the fiscal year. ***, **, and * indicate that coefficient is significant at the 1%, 5%, and 10% levels, respectively.

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Table 4 Multiple regression results of the relation between excess control and VC-backing. Panel A: Analysis of venture capitalist's likelihood of investing in a company (probit model) Coefficient INTERCEPT LEV PROFIT INVESTMENT RD

0.43 −1.08 −0.07 0.15 0.01

z 1.34 −1.81* −0.07 0.30 2.60***

Coefficient

z

0.43 −1.08 −0.07 0.15 0.01

1.34 −1.81* −0.07 0.30 2.60***

Panel B: Excess control and VC regression controlling for self-selection VOTING-OWNERSHIP

INTERCEPT VC OWNERSHIP CEOCHAIR FAMILY AGE SIZE AUDIT Lambda N F value Adj. R2

VOTING/OWNERSHIP

Coefficient

t-Stat.

Coefficient

t-Stat.

0.02 −0.04 −0.01 −0.03 0.15 −0.01 0.02 0.02 −0.08 223 19.16*** 0.54

0.16 −3.65*** −10.10*** −0.26 8.90*** −1.99** 2.34** 1.50 −2.14**

5.19 −1.60 −0.19 −0.78 4.83 −0.11 0.61 0.27 −8.45 223 3.87*** 0.36

1.10 −2.82*** −4.89*** −1.38 3.50*** −2.60*** 1.51 0.50 −1.81*

VOTING-OWNERSHIP: controlling shareholders' voting rights minus their cash flow rights; VOTING/OWNERSHIP: the ratio of the controlling shareholders' voting rights to their cash flow rights; VC: an indicator variable taking the value one if the firm at time t is a VC-backed firm and zero otherwise; OWNERSHIP: the percentage of the cash flow (ownership) rights owned by the controlling shareholders; CEOCHAIR: an indicator variable taking the value one if the CEO also serves as the chair of the board and zero otherwise; FAMILY: an indicator variable taking the value one if the firm is a family-controlled firm and zero otherwise; a firm is defined as a family-controlled firm if the controlling family controls at least 20% of a firm's control rights (e.g., Claessens et al., 2000; Faccio and Lang, 2002; La Porta et al., 1999; Yeh and Woidtke, 2006); AGE: age of the firm; SIZE: the natural logarithm of the firm total assets; AUDIT: an indicator variable taking the value one if the firm is audited by a Big-5 auditor and zero otherwise; LEV: the firm's leverage ratio at the beginning of the fiscal year, calculated by one minus the ratio of book value of equity to total assets of the firm at the beginning of the fiscal year; PROFIT: ordinary income deflated by total assets of the firm at the beginning of the fiscal year; INVESTMENT: capital expenditures deflated by beginning-of-year book value of assets; RD: R&D expenses deflated by beginning-of-year book value of assets. The t-statistics are based on White's (1980) standard errors. ***, **, and * indicate that coefficient is significant at the 1%, 5%, and 10% levels, respectively.

measures (VOTING-OWNERSHIP and VOTING/OWNERSHIP), on VC and a set of selected control variables. The results in these two regression analyses are similar. The coefficients for the VC-backed indicator are negative at the 1% and 5% levels, respectively. All control variables enter with anticipated signs in both regressions. Among them, the coefficients on OWNERSHIP and AGE are significantly and negatively related to EXCESS_CONTROL, while the coefficients on FAMILY and SIZE are significantly and positively related to EXCESS_CONTROL. Therefore, the results from both of the regression analyses support Hypothesis 1. Hypothesis 2 tests whether the governing effect of venture capitalists in firms with weak governance structure is greater than that with strong governance structure. To test this hypothesis, we first partition the sample firms into two subsample groups (firms with strong governance structure and firms with weak governance structure). We then run two separate regressions for these two subsample groups. Table 5 presents the results of regressing excess control (VOTING-OWNERSHIP) on VC and the selected control variables for each subsample group. Since there is no perfect proxy for strong and weak governance firms, we use two proxies to classify the sample firms into strong and weak governance groups. The first proxy measures the ownership of the controlling shareholders (OWNERSHIP) and the second proxy measures the percentage of the controlling shareholders sitting on the board (CONTROLBOARD). For the purpose of easy comparison of these results, Table 5 reports the results of four regression cases (2 firm groups × 2 controlling proxies). These results show that the coefficient on VC is significantly negative in subsample firms with weak governance but insignificant in those with strong governance regardless which proxy is

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Table 5 Multiple regression results of the relation between excess control (voting rights–cash flow rights) and VC-backing in subsample firms with weak governance and strong governance. Panel A: Analysis of venture capitalist's likelihood of investing in a company (probit model)

INTERCEPT LEV PROFIT INVESTMENT RD

Coefficient

z value

Coefficient

0.63 −0.93 −0.70 0.43 0.01

1.45 −1.03 0.56 0.66 1.02

0.42 −1.46 0.11 0.21 0.02

z value 1.12 −2.14** 0.10 0.38 2.52***

Coefficient

z value

Coefficient

z value

−0.41 −0.71 2.65 0.01 0.01

−0.71 −0.81 1.31 0.01 2.88***

0.37 0.83 0.74 −1.05 0.01

0.55 0.57 0.30 −0.93 1.01

Panel B: Excess control and VC regression in weak and strong governance firms controlling for self-selection Weak governance CONTROLBOARD ≥ 0.5

OWNERSHIP N 24

Coefficient

t-Stat.

Coefficient

t-Stat.

Coefficient

t-Stat.

Coefficient

t-Stat.

−0.02 −0.06 −0.01 −0.02 0.28 −0.01 0.01 −0.01 0.06 112 60.59*** 0.68

−0.18 −3.10*** −3.59*** −1.04 14.01*** −3.19*** 2.04** −0.48 0.75

−0.02 −0.03 −0.01 −0.01 0.16 −0.01 0.02 0.03 −0.01 171 21.84*** 0.61

−0.14 −2.36** −11.71*** −0.88 9.68*** −1.68* 1.91* 1.67* −0.43

−0.05 −0.01 −0.01 0.01 0.07 −0.01 0.01 0.03 0.02 111 2.54** 0.27

−0.29 −0.32 −2.89*** 0.62 2.14** −0.23 1.06 2.27** 1.04

−0.22 −0.02 −0.01 0.01 0.13 −0.01 0.02 0.01 0.01 52 1.98* 0.38

−1.70* −0.91 −2.49** 0.84 2.78*** −0.90 2.45** 0.36 0.02

OWNERSHIP ≤ 24

INTERCEPT VC OWNERSHIP CEOCHAIR FAMILY AGE SIZE AUDIT Lambda N F value Adj. R2

Strong governance c

CONTROLBOARD b 0.5

VOTING−OWNERSHIP: controlling shareholders' voting rights minus their cash flow rights; VC: an indicator variable taking the value one if the firm at time t is a VC-backed firm and zero otherwise; OWNERSHIP: the percentage of the cash flow (ownership) rights owned by the controlling shareholders; CEOCHAIR: an indicator variable taking the value one if the CEO also serves as the chair of the board and zero otherwise; FAMILY: an indicator variable taking the value one if the firm is a family-controlled firm and zero otherwise; a firm is defined as a family-controlled firm if the controlling family controls at least 20% of a firm's control rights (e.g., Claessens et al., 2000; Faccio and Lang, 2002; La Porta et al., 1999; Yeh and Woidtke, 2006); AGE: age of the firm; SIZE: the natural logarithm of the firm total assets; AUDIT: an indicator variable taking the value one if the firm is audited by a Big-5 auditor and zero otherwise; Lambda: the inverse Mills' ratio produced from the selection model; LEV: the firm's leverage ratio at the beginning of the fiscal year, calculated by one minus the ratio of book value of equity to total assets of the firm at the beginning of the fiscal year; PROFIT: ordinary income deflated by total assets of the firm at the beginning of the fiscal year; INVESTMENT: capital expenditures deflated by beginning-of-year book value of assets; RD: R&D expenses deflated by beginning-of-year book value of assets. The t-statistics are based on White's (1980) standard errors. ***, **, and * indicate that coefficient is significant at the 1%, 5%, and 10% levels, respectively.

used to classify the subsample groups. Therefore, these results indicate that the negative relationship between excess control and VC investments is significant in IPO firms with weak governance, but not in IPO firms with strong governance. All control variables appear to enter with significant signs except for AGE, CEOCHAIR, and AUDIT. The coefficient on AGE is significantly negative in the regression for subsample firms with weak governance but insignificant in the regression for those with strong governance. This result indicates that excess control is likely to be affected by the firm age in IPO firms with weak governance, but not in those with strong governance. In addition, CEOCHAIR and AUDIT enter with the anticipated signs and usually have insignificant coefficients. Similarly, Table 6 reports the results of regressing excess control (VOTING/OWNERSHIP) on VC and the selected control variables for each of the four regression cases. The results in Table 6 are mostly consistent with those presented in Table 5. The only exceptions are in the coefficients on SIZE, which enters with significant and anticipated signs in 3 out of 4 cases in Table 5 but only marginally significant in 2 out 4 cases in Table 6. Apart from this minor difference, Tables 5 and 6 display similar results in support of Hypothesis 2.

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Table 6 Multiple regression results of the relation between excess control (voting rights/cash flow rights) and VC-backing in subsample firms with weak governance and strong governance. Panel A: Analysis of venture capitalist's likelihood of investing in a company (probit model) Coefficient INTERCEPT LEV PROFIT INVESTMENT RD

0.63 −0.93 −0.70 0.43 0.01

z value

Coefficient

z value

Coefficient

z value

Coefficient

z value

1.45 −1.03 −0.56 0.66 1.02

0.42 −1.46 0.11 0.21 0.01

1.12 −2.14** 0.10 0.38 2.52**

−0.41 −0.71 2.65 0.01 0.01

−0.71 −0.81 1.31 0.01 2.88***

0.37 0.83 0.74 −1.05 0.01

0.55 0.57 0.30 −0.93 1.01

Panel B: Excess control and VC regression in weak and strong governance firms controlling for self-selection Weak Governance CONTROLBOARD ≥ 0.5

OWNERSHIP N 24

Coefficient

t-Stat.

Coefficient

t-Stat.

Coefficient

t-Stat.

Coefficient

t-Stat.

3.99 −2.79 −0.47 −1.39 5.01 −0.16 1.18 −0.83 −12.74 112 4.86*** 0.43

0.49 −2.40** −4.22*** −1.38 1.80* −1.78* 1.55 −0.74 −0.99

−0.39 −1.29 −0.23 −0.87 5.22 −0.13 0.95 0.81 −5.41 171 3.99*** 0.39

−0.06 −2.07** −4.97*** −1.28 3.48*** −2.66*** 1.66* 1.11 −1.42

1.13 −0.01 −0.02 0.01 0.25 −0.01 0.02 0.09 0.08 111 3.21*** 0.30

2.19** −0.04 −2.87*** 0.17 1.97* −0.58 0.79 2.35** 1.23

−1.72 −0.41 −0.05 −0.26 1.36 −0.02 0.30 0.04 0.58 52 3.38*** 0.21

−0.54 −0.90 −2.28** −0.84 2.91*** −1.16 1.55 0.11 0.52

OWNERSHIP ≤ 24

INTERCEPT VC OWNERSHIP CEOCHAIR FAMILY AGE SIZE AUDIT Lambda N F value Adj. R2

Strong Governance c

CONTROLBOARD b 0.5

VOTING/OWNERSHIP: the ratio of the controlling shareholders' voting rights to their cash flow rights; VC: an indicator variable taking the value one if the firm at time t is a VC-backed firm and zero otherwise; OWNERSHIP: the percentage of the cash flow (ownership) rights owned by the controlling shareholders; CEOCHAIR: an indicator variable taking the value one if the CEO also serves as the chair of the board and zero otherwise; FAMILY: an indicator variable taking the value one if the firm is a family-controlled firm and zero otherwise; a firm is defined as a family-controlled firm if the controlling family controls at least 20% of a firm's control rights (e.g., Claessens et al., 2000; Faccio and Lang, 2002; La Porta et al., 1999; Yeh and Woidtke, 2006); AGE: age of the firm; SIZE: the natural logarithm of the firm total assets; AUDIT: an indicator variable taking the value one if the firm is audited by a Big-5 auditor and zero otherwise; Lambda: the inverse Mills' ratio produced from the selection model; LEV: the firm's leverage ratio at the beginning of the fiscal year, calculated by one minus the ratio of book value of equity to total assets of the firm at the beginning of the fiscal year; PROFIT: ordinary income deflated by total assets of the firm at the beginning of the fiscal year; INVESTMENT: capital expenditures deflated by beginning-of-year book value of assets; RD: R&D expenses deflated by beginning-of-year book value of assets. The t-statistics are based on White's (1980) standard errors. ***, **, and * indicate that coefficient is significant at the 1%, 5%, and 10% levels, respectively.

5.3. Empirical results of VC on financial stability Hypothesis 3 tests whether VC-backed IPO firms encounter less financial difficulty or distress than non-VC-backed IPO firms following their public offerings. Table 7 presents the results of regressing PROBLEM on VC and a set of selected control variables that may account for financial difficulty or distress in IPO firms 7 years after public offerings. As expected, the coefficients on VC are significantly negative at the 10% level in both probit and logit regression analyses. These results indicate that VC-backed IPO firms are financially healthier and stronger than non-VC-backed IPO firms 7 years after the IPO. With respect to control variables, we find that OWNERSHIP, SIZE, VOTING, and LEV are not significantly related to financial difficulty or distress of the IPO firms following public offerings. However, control variables for other firm characteristics (PROFIT and AGE) in the IPO year have negative and significant effects on their financial distress or difficulty following initial public offerings. Overall, our results show that non-VC-backed IPO firms are more likely to encounter financial distress or difficulty than VC-backed IPO firms after public offerings.

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Table 7 Multiple regression results of the relationship between financial stability and VC-backing. Panel A: Analysis of venture capitalist's likelihood of investing in a company (probit model)

INTERCEPT LEV PROFIT INVESTMENT RD

Coefficient

z value

Coefficient

z value

0.43 −1.08 −0.07 0.15 0.01

1.34 −1.81* −0.07 0.30 2.60***

0.43 −1.08 −0.07 0.15 0.01

1.34 −1.81* −0.07 0.30 2.60***

Panel B: Financial stability and VC regression controlling for self-selection Probit model

INTERCEPT VC OWNERSHIP VOTING SIZE LEV PROFIT AGE Lambda N Wald chi2 Pseudo R2

Logit model

Coefficient

z value

Coefficient

z value

3.19 −0.46 0.01 −0.01 −0.26 1.64 −3.24 −0.05 0.38 223 21.92*** 0.16

1.14 −1.78* 0.19 −1.08 −1.45 1.20 −2.51** −2.48** 0.28

5.47 −0.79 −0.01 −0.02 −0.46 2.34 −5.37 −0.09 1.27 223 21.97*** 0.15

0.98 −1.65* −0.13 −0.84 −1.26 0.87 −2.19** −2.14** 0.48

PROBLEM: an indicator variable taking the value one if a firm at or before year t + 7 had financial distress or difficulty per the TEJ database, and zero otherwise; VC: an indicator variable taking the value one if the firm at time t is a VC-backed firm and zero otherwise; OWNERSHIP: the percentage of the cash flow (ownership) rights owned by the controlling shareholders; VOTING: the percentage of the voting rights controlled by the controlling shareholders; SIZE: the natural logarithm of the firm total assets; LEV: the firm's leverage ratio at the beginning of the fiscal year, calculated by one minus the ratio of book value of equity to total assets of the firm at the beginning of the fiscal year; PROFIT: ordinary income deflated by total assets of the firm at the beginning of the fiscal year; AGE: age of the firm; Lambda: the inverse Mills' ratio produced from the selection model; INVESTMENT: capital expenditures deflated by beginning-of-year book value of assets; RD: R&D expenses deflated by beginning-of-year book value of assets. The t-statistics are based on White's (1980) standard errors. ***, **, and * indicate that coefficient is significant at the 1%, 5%, and 10% levels, respectively.

5.4. Additional tests Although our sample accounts for 70% of the VC investments in Taiwan, it is still intriguing to investigate the results for the non-tech IPOs and see if the results are different between tech and non-tech IPOs. Therefore, we further investigate if our previous results are different between tech and non-tech IPOs. We add a dummy variable (TECH) which is equal to 1 if the firm is a high-tech IPO and an interaction term (VC ∗ TECH) into the regression to examine if our results are different between tech and non-tech IPOs. Untabulated results suggest that, after including these two variables into models (1) and (2), the interaction term (VC ∗ TECH) is insignificantly negative in both models, indicating that our results between tech and non-tech IPOs are not significantly different. 6. Conclusions Ownership concentration often leads to the agency problem of excess control in the emerging markets. This study examines whether the presence of venture capitalists mitigates excess control at the time of IPO and further ensures financial stability in the IPO firms after public offerings. Using data collected from Taiwan technology firms, we conduct three separate regression analyses to examine: (1) whether venture capitalists mitigate the level of excess control in the VC-backed firms at the time of IPO, (2) whether there are more mitigating effects of venture capitalists on excess control in IPO firms with weak governance

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structures than those with strong governance structures, and (3) whether financial stability in VC-backed firms is greater than non-VC-backed firms after the initial public offerings. As expected, our results show significant effects of venture capitalists on mitigating excess control by controlling shareholders at the time of IPO and ensuring financial stability in IPO firms after the IPO. Specifically, we first find that VC-backed IPO firms are more likely to have less excess control by controlling shareholders than non-VC-backed IPO firms at the time of IPO. This result indicates that venture capitalists significantly mitigate the agency conflict problem between the controlling shareholders and minority shareholders in the emerging markets. Second, we find that venture capitalists are more likely to mitigate excess control in IPO firms with weak corporate governance structures than those with strong corporate governance structures. 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