The selling choice of insiders in an initial public offering: A venture capital case

Because of the information advantage of insiders, outside investors react negatively to insider selling in new equity offerings. The negative reaction may keep insiders from selling their shares or make the cost of doing so outweigh the net present value of other investment opportunities. These concerns motivate insiders to establish a reputation of dealing fairly with outsiders. Insider reputation serves as an effective bond to convince outsiders that insiders will not sell overpriced issues when the present value of quasi-rents exceeds the one-time wealth transfer from the sale of shares. If reputable insiders can reduce the negative market reaction, they are expected to be more likely to sell their shares than nonreputable insiders.;Empirical evidence gathered from observing the selling practices of lead venture capital firms supports the above arguments. Reputable venture capital firms are more likely to sell their shares in initial public offerings than are nonreputable venture capital firms. Moreover, venture capital firms that stay in the venture capital industry longer are most likely to sell their shares. On the other hand, venture capital firms can not use the good reputation of underwriters to unwind their positions. In particular, reputable venture capital firms avoid insider selling that would account for a significant portion of the new issue. Finally, cross-sectional volatility of initial returns in issues with nonreputable venture capital firms is greater than that in issues with reputable venture capital firms.