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New business models combined with a lack of objective operating data result in significant information asymmetry and uncertainty in the valuation of new firms in emerging markets. Information asymmetry increases the risks of both adverse selection and moral hazard. When traditional differentiators of firm quality are lacking, such as in emerging economic sectors, markets may turn to secondary information sources to filter and sort firms. We investigate the roles played by observable corporate governance characteristics as indirect indicators of new firms ' potential qualitative differences. Markets may sort firms based on such characteristics because they are perceived to be correlated with desired but unobservable characteristics and actions and they lower the risks of both adverse selection and moral hazard. Our study of publicly traded U.S. Internet firms found that firm market valuation was strongly associated with corporate governance characteristics (e.g., executive and director stock-based incentives, institutional and blockholder stock ownership, board structure, and venture capital participation). In addition, firm age moderated how markets used some quality proxies to determine firm valuation during the post-IPO period. Copyright © 2003 John Wiley & Sons, Ltd.
Key words: signaling; corporate governance; IPO; valuation; Internet
Shareholders face many hazards investing in new businesses, but uncertainty is compounded when firms operate in new economic sectors (Aldrich and Fiol, 1994). Many years of data are typically available on established firms and their competitors. Additionally, professional education and training of institutional investors (e.g., mutual and pension fund managers) and investment bankers serve to diffuse knowledge and skills in standard valuation practices (DiMaggio and Powell, 1983). Markets typically rely on this codified knowledge and detailed analysis of financial, economic, and market data to reduce information asymmetry regarding inherent quality and to value firms (Reilly and Brown, 1999) because such information reduces governance uncertainty (Alchian and Woodward, 1988; Boisot and Child, 1996). However, during the emergence of new industries, investors and analysts lack a codified body of knowledge and industry-specific experience. In these contexts, firms often operate with new and unproven business models and compete against many rival start-ups, all jockeying for early market dominance. Information asymmetry is particularly problematic in new economic sectors because managers have great discretion over scarce financial capital and investors are inexperienced in these domains (Alchian and...