Top Management Team Heterogeneity and Faultlines in Initial Public Offering Firms

Transcription

1 ASAC 2007 Ottawa, Ontario Martin L. Martens Natalya Totskaya (Student) Ohad Raveh (Student) John Molson School of Business Concordia University Top Management Team Heterogeneity and Faultlines in Initial Public Offering Firms This article introduces the group faultlines concept into the top management team literature. We use data from the TMTs of 299 initial public offering firms and examine the impact of faultlines and heterogeneity on IPO firm performance. We show that longterm performance is associated with both faultlines and heterogeneity but with opposite effects. Introduction In this article we introduce a new concept, group faultlines (Lau & Murnighan, 1998; 2005), into the literature on entrepreneurial top management teams. A group faultline is a hypothetical line, a split within the group, created by common demographic characteristics that serve to form two or more subgroups. Group faultlines, and the factional groups that result, are believed to create conflict and communication difficulties between the sub-groups and these problems have the potential to reduce overall group performance (Lau & Murnighan, 2005; Li & Hambrick, 2005). While TMT heterogeneity has received considerable attention among management researchers during the past two decades, the faultlines concept offers a new method for understanding why heterogeneity may have an impact on firm performance. To examine this concept, and its relationship to TMT heterogeneity, we structure the paper in the following way: First, we provide an overview of the TMT heterogeneity literature, with a specific focus on its association with firm performance. Second, we provide an explanation of the group faultlines concept and its relationship to group heterogeneity. Third, we then produce three hypotheses that predict the associations for short and long-term firm performance to TMT heterogeneity and TMT faultlines. Fourth, we then present the results of an empirical investigation of TMT heterogeneity and TMT faultlines in 299 firms that completed initial public offerings between the years 1996 and Finally, we finish with a discussion of the implications of the faultlines concept on the TMT literature. An Overview of the TMT Heterogeneity Literature The Upper Echelons perspective (Hambrick & Mason, 1984; Finkelstein & Hambrick, 1996; Carpenter, Geletkanycz, & Sanders, 2004) has attracted substantial interest from strategy researchers for more than two decades. Of the many niches within this literature, one of the more considerable niches is research that focuses on Top Management Team (TMT) heterogeneity. This literature examines Top Management Teams in terms of demographic composition, dynamics and subsequent firm outcomes. Hambrick and Mason (1984) identified a number of major demographic characteristics and used these as the basis of their theoretical model of executive behaviour. Hambrick and Mason s (1984:197) assertion that executive backgrounds are reflected in strategic outcomes has lead to two primary avenues of research. The first includes research that examines the connections between TMT demographic composition and performance outcomes. The second is a reflection of the interdisciplinary nature of upper echelon theory. In this avenue, researchers have taken TMT composition into consideration but focused on TMT cognitive processes and their subsequent effects on firm performance. Although widely represented in the literature, these two avenues of research appear to be developing independently. The first avenue represents the macro-level of analysis common to the 89

2 strategic management field. The second avenue represents the micro-level more common to social psychology and organisational behaviour perspectives. Each group of researchers acknowledge the validity of the basic theory and complexity of top management team effects. While consistent with theoretical backgrounds proposed by Hambrick and Mason (1984), the empirical findings are mixed. Top management team researchers not only focused on different issues within upper echelons theory, but also tend to use disparate or inconsistent definitions, terminology and research methodology. Definitions given of top management team vary significantly among empirical researchers (for examples see Carpenter et al., 2004: ). In this paper, we define the top management team as the primary group of executives involved in strategic decision making. TMT heterogeneity is defined as dissimilarity of one or more characteristics of team members and is considered a synonym with TMT diversity. The upper echelon perspective was first introduced by Hambrick and Mason (1984). Building on earlier findings in strategy and organisational studies, they argued that complex decisions were based on cognitive factors that reflected the values, powers and other characteristics of top executives, the most powerful actors in organisations. Hambrick and Mason stressed the importance of top management team as a critical unit of analysis. Observable demographic characteristics were emphasized over psychological ones as they were easier to measure, and considered to be more important and appropriate for strategic analysis (Hambrick & Mason, 1984). They proposed that firm outcomes were shaped by the background characteristics of top management team members such as age, functional track, career experiences, formal education, socioeconomic background, organisational tenure, financial position within a firm. They also noted that heterogeneity of top management team may be important as it had the potential to create subgroups within executive coalition. Other researchers support the idea that the composition of the top management group would affect firm performance, and that this effect would depend on environmental conditions (Murray, 1989:137), and that organisational performance is more strongly associated with top management team demographic composition than simple characteristics such as top management team size (Bantel & Jackson, 1989). Finkelstein and Hambrick (1996) provided the first substantial overview of the upper echelons perspective in their book Strategic Leadership: Top Executives and Their Effects on Organisations. In this book, they reviewed the development of the strategic leadership research over the previous decade, including the literature that focused on the top management team and provided an overview summary of how demographic characteristics of top managers affect organisational outcomes. Among the results they found the following: Executive tenure is inversely associated with organisational change and risk taking, positively related to strategic emphasis on stability, efficiency and performance alignment with average performance in industries. The functional background of the executives was associated with the type of the firm s competitive and diversification strategies. Higher levels of educational background among the TMT is positively associated with innovation, cognitive complexity, and organisational performance of the Prospector type of firm. Educational level serves as a moderator to firm responses to market trends but its effects and driving forces still require additional research. Finkelstein and Hambrick concluded that most of the studies in this literature concentrated on situational moderators to top management team outcomes (for details see Finkelstein & Hambrick, 1996: ). Carpenter et al. (2004) provides a more recent review of the upper echelon literature. They report that studies provide a wide range of, and sometimes contradictory, conceptual and operational definitions for a top management team. Even so, these studies, and the wide variety of measures used, have produced fairly consistent results that show significant associations between firm performance and top management team heterogeneity in terms of TMT characteristics. For example, Haleblian and Finkelstein (1993) found positive and significant connections among top management team size, top management team 90

3 characteristics, uncertain environment, and firm performance. Carpenter (2002) showed that TMT heterogeneity may allow managers to cope with more complex situations but this will likely increase socio-cognitive conflicts within the TMT. Tenure tends to reduce these conflicts but it is positively associated with the TMT s commitment to the status quo, team information diversity, and attitudes toward risk. Top management team characteristics appear to be critical when managers have full room to manoeuvre. The internal organisational environment appears to have an influence on the top management team through inertial forces (particularly, in large organisations) and through resource availability (Finkelstein & Hambrick, 1990: 489). However, the organisational culture, as well as individual members of top management team, may limit the discretion of top management team actions. Managerial discretion is considered to be an important moderator of top management team characteristics and outcomes and should be included into upper echelon theory (Finkelstein & Hambrick, 1990; Barker & Patterson, 1996). They also found that managerial tenure is an important organisational construct and noted that management team tenure has a profound influence on organisational outcome. The apparent effect of tenure is not just an artefact of the radical changes brought on by top managers newly arrived from the outside (Finkelstein & Hambrick, 1990: 501). In a diverse range of contexts, other researchers have found a variety of relationships between various TMT demographic characteristics and firm performance. Goll, Sambharya, and Tucci (2001) reported a positive relationship between progressive decision making and top management team heterogeneity, using age, functional background, and business education as relevant characteristics. Outside top management team members (older but with less tenure with the firm) were found to positively contribute to firm performance but, overall, the effects of heterogeneity on firm performance were mixed. Pegels and Yang (2000) focused on demographic and cognitive characteristics of top management team in their demonstration that demographic heterogeneity of top management team had a positive impact on firm performance while cognitive characteristics had no apparent influence. Carpenter (2002) found a positive association between top management team heterogeneity and firm performance that was moderated by the complexity of the firm s environment. The relationship was stronger for firms with higher levels of internationalization and for firms with lower tenure, on average, among top management team members. Carpenter and Frederickson (2001) found that international experience and educational heterogeneity affect top executives' managerial skills, demonstrating complex but positive relations with multinational firm performance. The hypothesized moderating effects of uncertainty received mixed support and need further examination. A positive association between international experience and international expansion were found in multinational corporations (Sambharya, 1996) and for small and medium enterprises (Reuber & Fischer, 1997). Tihanyi et al. (2000) reported that age, tenure, level of education and international experience appear to be significantly associated with higher international activity of a firm. Top management team heterogeneity in general and the top management team composition may have a significant influence on the international diversification decision (Tihanyi et al., 2000), although the causal direction of this influence is not entirely clear. These results support the idea that top management team heterogeneity in terms of international experience predicted a stronger international presence for the firm A further development in the upper management perspective was provided by Knight et al. (1999), who examined the effects of top management team characteristics on team processes with a specific attention to strategic consensus within the TMT. Their findings suggest that demographic characteristics (functional background and education) affect executive cognition and that demographic diversity within top management team is negatively related to strategic consensus. Thus the effects of demography are both direct and indirect as other factors may be influencing top management team consensus, and initiating different types of conflict. Knight et al. (1999) suggested that cultural influences, teamwork and cooperation within top management team, and power distribution may affect top executives behaviour. Consistent with Priem (1990), they suggested the need for further research on the 91

4 links between top management team consensus and performance. These complex relationships within the top management team were also addressed in Geletkanycz and Hambrick s (1997) research on executives' boundaries. They noted that executive social interaction is facilitated by more external ties, which increases creativity and helps the firm challenge established strategies. However, a conformist approach to strategy appears to be advantageous if a firm operates in a highly uncertain environment. The bulk of these studies, however, contain largely static, cross-sectional analyses (Finkelstein & Hambrick 1996). There are a few articles, however, that contain a somewhat more dynamic approach. These interdisciplinary studies represent a process related line of inquiry. Priem (1990) argued that top management team heterogeneity was negatively linked to top management team consensus. He found a non-linear relationship between top management team consensus and firm performance that was moderated by a dynamic environment. The lack of more dynamic, longitudinal analyses prompted Smith et al. (1994) to note that "no empirical studies have directly investigated the process through which the top management team's demography influences organisational outcomes" (Smith et al., 1994: 413). To address this short-coming, they proposed a model that includes communication and social integration as part of top management team processes. Smith et al. test three alternative models, linking team demography with process and organisational performance; they found that TMT demography and TMT processes influence performance both separately and through mediating effects. They concluded that the relationships among the components of the model "are not as straightforward or as simple as scholars have previously believed" (Smith et al., 1994: 432). Using a broader, interdisciplinary perspective, Hodgkinson and Sparrow (2002) summarized the major lines of research in the top management team literature. They noticed that, in traditional lines of research, a number of indicators were designed to describe composition of top management team and predicted associations between top management team demography and organisational outcomes. Although research designs involving sophisticated, multivariate statistical procedures have been used to empirically test and advance Upper Echelons theory, Hodgkinson and Sparrow (2002)contend that there are fundamental limitations in existing use of demography as a simplified external descriptor of complex problems. They propose a new direction for research that incorporates a socio-cognitive psychological approach to top management team studies and a more direct assessment of top management team individual and group characteristics. They pointed to the Knight et al. (1999) study as an example of integrating social cognition into top management team processes, and approved of the quality of measures and depth of results used. Hodgkinson and Sparrow pointed to a fundamental dilemma for strategic management research. They were concerned to whether "top executive teams should encourage cognitive diversity and/or homogeneity in the quest to ensure long-term survival and well-being of their organisations". (Hodgkinson & Sparrow, 2002: 192) One of their proposed methods for addressing this dilemma is the use of the group faultlines concept (Lau & Murnighan, 1998, 2005). Group Faultlines Lau and Murnighan (1998; 2005) introduced the group faultlines concept into the demographic diversity narrative as a way of explaining potential issues that might arise as a result of the group compositional dynamics created in groups with multiple attributes. A group faultline occurs when the group contains a hypothetical line that is created by a split in the demographic characteristics of two or more subgroups. A strong faultline exists when two distinct, non-overlapping subgroups are created by two or more attributes. For example, a five person top management team composed of two men with Finance MBAs and three women with engineering backgrounds would be considered to have a strong faultline. A five person top management team with five men, two of whom have marketing backgrounds, and three with accounting backgrounds would be a weak faultline. A group with either very low or very high levels of diversity on relevant demographic attributes is not likely to have a faultline. Very high levels of demographic heterogeneity tend to create the condition where no distinct subgroups exist. 92

5 Group faultlines are considered to create a different dynamic than heterogeneity. While high levels of TMT heterogeneity appear to lead to positive outcomes (Certo, Lester, Dalton, & Dalton, 2006), the existence of strong faultlines creates the potential for group conflict and decreased communication (Lau & Murnighan, 1998; 2005) that leads to high levels of group conflict which then tends to lead to poor performance (Jehn, 1995). The only studies to date on executives that have used the faultline concept were two articles that examined joint venture executive group composition (Hambrick, Li, Xin, & Tsui, 2001; Li & Hambrick, 2005). Li and Hambrick (2005) apply the label factional groups to the incompatible subgroups created by a strong faultline. This research supports the idea of group faultlines that reflect observable demography of managers. Faultlines appeared to limit within-group communication, increase conflict and decrease the performance of the joint venture. The faultlines and factional groups concepts offer a potential new tool for cracking open the black box connecting top management team characteristics and firm outcomes (Lawrence, 1997). Although the faultlines concept is new to the TMT heterogeneity literature, there is some research that examines TMT heterogeneity, conflict, and performance (e.g. Amason, 1996; Amason & Sapienza, 1997; Amason & Mooney, 1999; Knight et al., 1999). The exact relationship among these variables, however, is not clear and the empirical results are inconsistent (Chowdhury, 2005). Certo et al. s (2006) meta-analyses tested two competing hypotheses, that TMT heterogeneity is either positively or negatively associated with performance. Their analyses produced a significant and positive association for firm performance to TMT functional and executive tenure heterogeneity but not for educational or firm tenure heterogeneity. Their analyses produced no significant negative association between firm performance and TMT heterogeneity. The positive relationship, however, was fairly weak and there appears to be a number of intervening variables, such as communication and social integration (Certo et al., 2006; Pelled et al., 1999). These results appear to be consistent with the logic that group faultlines reduce communication and the resulting conflict would reduce social integration (Lau & Murnighan, 2005). Li and Hambrick (2005) in particular, found that faultlines are negatively related to TMT group performance and, for joint ventures, social integration and relational conflict mediate that negative relationship. Faultlines effects on managerial behaviour are not straightforward, and social context appears to play an important role in stimulating or reducing faultline appearance and strength. Sawyer, Houlette, and Yeagley (2006) found no significant differences between homogenous and diverse groups of managers, but pointed to the importance of social categories created by salient attributes that may create noticeable sub-groups created by faultlines (Sawyer et al., 2006: 13). Faultlines research to date does not provide consistent evidence on the effects of faultlines on TMT processes but that is likely due to an insufficient number of studies done on executive managers samples, rather than complexity of faultlines effects. As van Knippenberg and Schippers (2007) note, the faultlines concept adds value to the diversity literature, but the relationship between faultlines and their effects are not yet established. They suggested further studies connecting faultlines, in-group categorization and other predictors of group behaviour and performance. A substantial body of research is needed to explore and examine the impact of faultlines on TMT and its association with heterogeneity and performance. TMTs in Entrepreneurial and IPO Firms Since context is critical to a research study (Johns, 2006) and since our research has a specific focus on TMT heterogeneity in IPO firms, in this section we review the effects of heterogeneity on entrepreneurial teams in IPO firms. Chowdhury (2005) contends that TMT composition and diversity have been an important niche within the entrepreneurial team literature. He notes that the relevant literature is mixed on the effects of diversity for entrepreneurial teams as increased heterogeneity may 93

6 improve innovation but it may also create conflicts within the team. Beckman and Burton (2007) find that diversity, particularly functional diversity and TMT experience, improve firm performance. Higher levels of diversity lead to greater venture capital (VC) funding and shorter time to the IPO. VC financing leads to changes in the TMT that increase the diversity of the TMT and shorten the time to the IPO. Negotiating the complicated requirements involved in restructuring a firm as it prepares for an IPO is a complex and difficult task (Beckman & Burton, 2007; Martens, 2004). Greater heterogeneity within a TMT is generally associated with greater abilities to solve difficult problems, generate creative solutions, and manage complex choices (Bantel & Jackson, 1989; Chowdhury, 2005). Since VCs appear to generate greater levels of heterogeneity within the TMT (Beckman & Burton, 2007), it would follow that they perceive a benefit in doing so. Shorter times to IPO are generally associated with better IPO performance, although this can depend on market timing (Lowry & Schwert, 2002). Assuming that institutional investors are the informed investors assumed by signaling theory (Grinblatt & Hwang, 1989) then it seems likely that these investors would evaluate and hold a generally positive assessment of higher levels of TMT diversity when they evaluate and purchase initial public offerings. This suggests that: H1: Higher levels of TMT heterogeneity will be positively associated with better firm performance at the time of the IPO. Since we argue that TMT heterogeneity is generally associated with positive performance for IPO firms and TMT faultlines and factional groups are associated with conflict and poor performance, it would seem likely that an entrepreneurial TMT that has conflict and communication problems would not be a probable contender for getting into the IPO process, much less successfully completing an IPO. As such, we do not expect to observe any relationships between TMT faultlines and performance at the time of the IPO. Additionally, since the TMT of IPO firms are often assembled in the year or two prior to the IPO (Martens, 2004; Riaz & Martens, 2006) the conflicts may not have an impact until a considerable amount of time after the IPO. Thus we posit the following: H2: Higher levels of TMT faultlines will be negatively associated with better longterm firm performance after the IPO. The empirical research on long-term effects of TMT heterogeneity in entrepreneurial teams, however, seems consistent with the opposite relationship. As noted earlier, Certo et al. s (2006) metaanalyses found a positive relationship between some types of TMT heterogeneity and firm performance but no negative relationship to any type of TMT heterogeneity. Kor (2003) found a positive relationship to experience heterogeneity and entrepreneurial firm growth. The need for greater abilities to solve difficult problems, generate creative solutions, and manage complex choices (Bantel & Jackson, 1989; Chowdhury, 2005) would not likely halt at the time of the IPO and thus it seems plausible to extend the same logic for IPO performance to long-term performance in the years following the IPO. This suggests that: H3: Higher levels of TMT heterogeneity will be positively associated with better longterm firm performance after the IPO. Methodology Data. To test our hypotheses, we used a data set of 299 computer software firms. The firms were chosen for inclusion in this single industry analysis on the basis of the company s description in the summary section at the start of the firm s 424B filing. We selected firms that described one of their primary business lines as computer software development. All the firms in this data set classified 94

7 themselves in the 2-digit SIC classification 73xx (Business Services) and three-quarters used the SIC 737x Computer Software code. These 299 firms represent 70% of the 425 computer software firms, excluding spin-offs, that completed an IPO on a USA stock exchange between June 1996 and December With the exception of the long-term performance variable, all data used in this study were obtained from the 424B filing that a firm must file with the U.S. Securities and Exchange Commission following the completion of the offering. The 299 firms, of the 425 firms available, were included if there was complete information available for all relevant demographic characteristics and on the basis of the number of top management team members reported in the Management section of the firm s 424B filing. We included firms that listed from four to eight top management team members in filing. We dropped twenty-nine firms from the analysis because their filings contained insufficient information to determine the attributes for all of the relevant demographic characteristics used for the faultlines variable. We excluded fifteen firms that listed only three top management team members because those top management teams could not have multiple sub-groups containing two or more members. Finally, we excluded ninety-one firms from the analysis that reported nine or more top management team members. These were dropped because of the complexity of the faultlines variable calculations. Each time the number of TMT members increased by one, the number of possible sub-groups increased by a factor of four. The additional firms added into the data set diminished dramatically for firms reporting more than eight TMT members. We explain the calculation of the faultlines measure below. Independent Variables. For both the heterogeneity variable and the faultlines variable, we first had to determine the relevant demographic characteristics to include in the calculations. As discussed above, the TMT literature provides a fairly comprehensive set of potential characteristics. Management teams of entrepreneurial firms appear to benefit from a diversity of experience (Eisenhardt & Schoonhoven 1990; Beckman & Burton, 2007). These include founding experience and prior experience (Beckman & Burton, 2007); age and functional background (Goll et al., 2001); and firm tenure (Carpenter, 2002; Finkelstein & Hambrick, 1990). The important criterion for the creation of a faultline is the inclusion of relevant characteristics that have the potential to create sub-groups with strong faultlines between the sub-groups. For this study we used seven demographic characteristics: Age; gender; firm tenure; board of director membership; functional background; founders; and shared prior firm experience. BOD membership identified TMT members who were also members of the BOD. The founder category classified members as a founder if they were part of the management team when the company was founded. The prior shared firm experience looked at whether or not two or more members worked at the same firm before joining the IPO firm. We compared all reported prior firms for each top management team member for up to three prior firms. It is possible that some TMT members previously worked together in the same firm but were not included in our calculation because it was not reported in the management section. For the faultlines variable, we used the fau calculation reported in Thatcher, Jehn, and Zanutto (2003). Fau is a calculation of the strength of the strongest possible faultline split and is a percentage of total variation. We calculated the faultline strength only for all possible sub-groups of two or more members for each of the seven demographic characteristics and did not include sub-group calculations that would have included only one member. Fau is a calculation of the ratio between the group sum of squares and the total sum of squares for each characteristic. The algorithm used calculates the faultline strength for all possible subgroups on two or more dimensions and reports the highest value. The value can range from 0 to 1 where a higher value indicates a stronger faultline. Our data included values that ranged from.150 (a very weak faultline) to.928 (a very strong faultline). (See Thatcher et al., 2003 for a more detailed explanation on the calculation of fau.) Following an approach consistent with established methods found in earlier group faultlines research (Bezrukova, Thatcher, & Jehn, In Press), we use the entropy index (Ancona & Caldwell, 1992) 95

8 to measure group heterogeneity for categorical variables (gender, BOD membership, founders, functional background) calculated as ΣP i (lnp), where P represents the fractional share of members within a particular attribute category and i is the number of different categories represented on a team. We used the coefficient of variation (attribute standard deviation/attribute mean) as the measure for continuous variables (age, firm tenure) (Allison, 1978). The total heterogeneity index is the total sum of the values for each heterogeneity score for all attributes. Dependent Variables. Even though there is a substantial empirical research literature that examines IPO performance, or perhaps because of the substantial literature, there is no standard measure of IPO performance (Certo et al., 2003; Lester et al., 2006) we include two standard measures of IPO success, valuation and underpricing. IPO valuation represents the gross proceeds collected by the firm in the offering. Controlling for other relevant factors, a more successful firm will collect more money in the IPO. This is a fairly straight-forward measure of the success of the IPO. Underpricing is the difference between the closing price at the end of the first day minus the issue price of the IPO. Underpricing represents money left on the table (Loughran & Ritter, 2002) and higher underpricing is considered to be lower performance for the firm. Because both of these variables are left-skewed, we transformed each using the natural log. We test long-term IPO performance by determining whether or not a firm is still listed on the stock exchange three years after the IPO. This delisting failure is defined as being delisted from the stock market within 3 years after the IPO date where 1 equals delisting. The 3-year period was chosen because prior research found that a significant percentage of IPO firms during this period survive for the first 2 years post-ipo but fail in the third year (Ritter & Welch, 2002). We do realize that firms may be delisted because they fail to conform to SEC or stock exchange requirements or because they are acquired by another firm. An acquisition by another firm may or may not be considered negative, especially if the firm is acquired at a price above its IPO valuation. We define a delisting failure as one where, within the first three years, the firm is delisted for failing to meet SEC or exchange requirements or if it was acquired by another firm at a stock market-adjusted value that was seventy-five percent below its IPO valuation or lower. We acknowledge that the 75% level is an arbitrary level but we felt that it was a quite stringent standard that strongly indicated a failure even if the firm had been acquired. Losing 75% of its value on the market prior to being acquired is a substantial loss and we argue that it should be considered a failure. Control Variables. We include a number of standard control variables that are known to have an impact on IPO firm performance. This includes firm level and market level variables. Since younger firms are more fragile (Stinchcombe, 1965) and older firms tend to perform better both before and after the IPO (Ritter, 1998), we control for firm age at the time of the IPO. Firm size is also taken into account as it may influence variables such as valuation. Since our sample only contains young computer software firms, we use the number of employees at the time of the IPO as a measure of firm size and then convert it to the natural log of the number of employees at the time of the IPO because of the skewness of the data. We use Loughran and Ritter s (2004) underwriter prestige measures to control for underwriter reputation as this is a well-known influence on the valuation and underpricing of IPOs (Carter & Manaster, 1990; Carter, Dark & Singh, 1998; Ritter & Loughran, 2004). We include a control for the effect of Founders on the top management team. Prior research has shown that the presence of founders on the top management team is associated with lower valuations, higher underpricing, and better long-term performance (Wasserman, 2003; Nelson, 2003). We include a measure of ex-ante risk, using the BROAD risk measure developed in MacCrimmon and Martens (2001). This is a measure that examines the risk factor section of the IPO prospectus and counts the number of times any one of ten specific risk factors appears in the section. The measure is a value from zero to ten where a zero indicates that none of the ten specific risk factors appear in the prospectus section and a ten indicates that all ten appear in the section. MacCrimmon and Martens (2001) find a high BROAD measure to be associated with lower IPO valuations, higher 96

9 underpricing, and lower long-term performance during the 1996 to 2000 period. This measure is more refined than simply counting the number of risk factors (Beatty & Ritter, 1986; Clarkson & Merkley, 1994) and is consistent with other risk factor measures (Welbourne & Andrews, 1996). We include three market related control measures. NASDAQ prior 30 days return controls for the NASDAQ market performance in the 30 days prior to the IPO. The variable is measured as the percentage return on the NASDAQ index during the 30 calendar days prior to the IPO date. NASDAQ 3-year return is the percentage change in the NASDAQ QQQ index over the period matching either three years after the IPO issue date or until the firm was delisted. The NASDAQ was chosen for this control because of the large majority of the issues in our sample trade on this exchange. We also included the IPO Bubble variable to account for the hot IPO bubble time period (Ljungqvist & Wilhelm, 2002). We also include controls for the fau calculation, the Number of TMT members, since fau is sensitive to the number of group members and tends to decrease, on average, as the number of group members increases (Bezrukova, Thatcher, & Jehn, In press). We test our hypotheses on IPO valuation and underpricing using OLS regression analysis and use logistic regression for the 3-year delisting analysis. Results Table 1 above provides the descriptive statistics and correlations for the variables in our study. Tables 2 through 4 provide the results of the regression analyses (N=299 for all analyses). Table 1: Descriptive Statistics and Correlations Variable mean s.d TMT Fau TMT Heterogeneity Ex-ante Risk Firm Age IPO Bubble Ln(Underpricing) Ln(Valuation) Ln(Employees) Underwriter Prestige NASD 30 day Return NASD 3 yr Return year delisting failure # of TMT members # of Founders on TMT Note:.12 = p<.05;.15 = p<.01;.19 = p<.001 N=299 Table 1: Continued year delisting failure # of TMT members # of Founders on TMT

10 The descriptive statistics provide us a sense of the typical firm contained within the data. The average firm is seven years old, has 336 employees, six TMT members, and collected US$67 million in the IPO. In general, these are fairly young but mid-sized firms. The average issue price was $14 and the average first day closing price was $25, producing an average underpricing of $11. The correlation tables provide a few interesting results. A higher level of overall TMT heterogeneity is significantly and negatively associated with firm size, which is a counter-intuitive indication that larger firms tend to have less heterogeneous top management teams. There is a marginally significant (p<.055) positive correlation between TMT heterogeneity and ex-ante risk. The correlations also provide an indication of the validity of various measures. As what would be expected, higher ex-ante risk is significantly and positively correlated with underpricing and the IPO Bubble period, and negatively correlated with firm age and firm size. Higher underwriter prestige is positively associated with valuation and negatively associated with 3 year delisting failure. In general, the pattern of bivariate correlations for underpricing, valuation, and underwriter prestige are consistent with prior IPO research (Loughran & Ritter, 2004; Ritter & Welch, 2002). It is also important to note that TMT fau and TMT heterogeneity are not significantly correlated. In each table below, we report four models. All coefficients reported are unstandardized. The first model contains the control variables, the second model enters in fau, the faultlines measure, the third model contains the controls and TMT heterogeneity, and the fourth is the full model and contains both fau and TMT heterogeneity. There are a few noteworthy results among the control variables. Riskier firms, as indicated by the ex-ante risk measure, are associated with higher valuations, greater underpricing, and higher likelihood of being delisted three years after the IPO. Greater underwriter prestige is associated with higher valuations, greater underpricing, and a lower likelihood of being delisted. These results are consistent with prior research (Loughran & Ritter, 2004; Clarkson & Merkley, 1994; MacCrimmon & Martens, 2001; and Ritter & Welch, 2002) and this suggests that our data appears to be typical of IPO firms for this period. Table 2: Dependent Variable Ln(Valuation) Model 1 Model 2 Model 3 Model 4 Variable b s.e. b s.e. b s.e. b s.e. Intercept 0.513*** *** *** *** 0.18 Ex-ante Risk 0.020*** *** *** *** 0.01 Firm Age IPO Bubble 0.117*** *** *** *** 0.03 Ln(Employees) 0.254*** *** *** *** 0.04 NASD 30 day Return 0.005*** *** *** *** 0.00 Underwriter Prestige 0.071*** *** *** *** 0.01 # of TMT members # of Founders on TMT TMT Fau TMT Heterogeneity R % 37.0% 37.5% 36.4% Adj R % 35.0% 35.6% 34.1% = p.10; * = p.05; ** = p.01; *** = p.001. N=299 98

11 Table 3: Dependent Variable Ln(Underpricing) Model 5 Model 6 Model 7 Model 8 Variable b s.e. b s.e. b s.e. b s.e. Intercept *** *** *** *** 0.21 Ex-ante Risk Firm Age IPO Bubble 0.139*** *** *** *** 0.04 Ln(Employees) NASD 30 day Return 0.004*** ** * * 0.00 Underwriter Prestige 0.056*** *** *** *** 0.01 # of TMT members 0.019*** ** * # of Founders on TMT 0.125*** *** *** *** 0.04 TMT Fau TMT Heterogeneity R % 24.9% 23.4% 23.5% Adj R % 22.5% 21.0% 20.7% = p.10; * = p.05; ** = p.01; *** = p.001. N=299 Table 4: Dependent Variable - 3 Year Delisting Failure Model 9 Model 10 Model 11 Model 12 Variable b s.e. b s.e. b s.e. b s.e. Intercept Ex-ante Risk Firm Age * *** *** *** 0.03 IPO Bubble Ln(Underpricing) Ln(Valuation) Ln(Employees) NASD 30 day Return 0.025* NASD 3 yr Return Underwriter Prestige * ** * * 0.13 # of TMT members # of Founders on TMT TMT Fau * 1.46 TMT Heterogeneity * * 0.23 Log Likelihood *** *** *** *** Model R 2 6.6% 8.3% 8.4% 9.5% = p.10; * = p.05; ** = p.01; *** = p.001. N=299 99

12 Tables 2 and 3 provide multiple tests for Hypothesis 1, that greater TMT performance is positively associated with performance at the IPO. Positive IPO performance for the firm would translate into higher valuations, more money collected, and lower underpricing, less money left on the table. The coefficients for TMT heterogeneity, however, are not significant for any of the models in either table, thus the results do not support Hypothesis 1. Since the literature generally supports the idea that TMT diversity has a positive impact on firm performance, our conceptual model contained the inference that IPO firms would be rewarded for higher levels TMT diversity. IPO valuation is the gross proceeds collected from the IPO and the vast majority of IPO shares are purchased by institutional investors (Ritter & Welch, 2002). Thus IPO valuation is an appropriate proxy for institutional investor perceptions of the value of the firm. The results, however, do not support the idea that institutional investors value TMT heterogeneity. Our second dependent variable, underpricing, is the difference between the issue price and the closing price at the end of the first day. This difference is considered to be a measure of the information asymmetry between the informed investors (the institutional investors who purchase shares at the issue price) and the uninformed investors (the retail market investors who purchase shares once the firm starts trading) (Beatty & Ritter, 1986; Grinblatt & Hwang, 1989). When compared to the results for IPO valuation, significant associations to higher underpricing, could reasonably be interpreted to mean that the retail market is, for whatever reason, placing a higher value on the firms than the value assigned by the institutional investors. Unfortunately, since there are no significant coefficients for TMT heterogeneity, we are unable to infer that retail investors place any value on TMT diversity. Thus our results do not provide any support for the argument that either type of investors place any additional value on TMT diversity. As an additional note, we did not expect to observe any relationship between TMT faultlines and IPO performance and the results are consistent with this supposition. The coefficients in Table 4 provide considerably more intriguing results. The coefficients for TMT fau in both models 10 and 12 are significant and positive. Stronger faultlines are positively associated with delisting failure within the 3 years after the IPO and this result supports Hypothesis 2. Additionally, the statistical significance for the fau coefficient increases from a p-value of.08 in Model 10 to a p-value of.05 in Model 12. When controlling for the level of heterogeneity in the TMT, the impact of TMT faultlines appears to significantly increase, providing additional support for Hypothesis 2. Conversely, we posited a positive relationship between TMT heterogeneity and long-term IPO firm performance. The coefficients in Models 11 and 12 for TMT heterogeneity are significant and negative. The negative coefficient means that higher levels of heterogeneity decrease the likelihood that a firm will be delisted for a negative reason within the three years following the IPO. This result provides support for Hypothesis 3 and is consistent with the argument that higher levels of TMT heterogeneity are positively associated with better firm performance, at least as measured by continued market presence. In combination, the results for TMT faultlines and TMT heterogeneity are thought-provoking results. It is remarkable that the increase in variance explained is essentially the same for TMT faultlines and TMT heterogeneity. In both cases, the R-squared value increases by approximately 1.75%. It is also worth noting that the variance increases by another 1.1% in Model 12 when both variables are included in the regression simultaneously. This result suggests that faultlines and heterogeneity separately and jointly make unique and significant contributions to explaining variance in long-term firm performance. Discussion In this article we provide the first empirical test of the group faultlines concept (Lau & Murnighan, 1998; 2005) within the context of entrepreneurial top management teams. Although our results did not produce the expected association between TMT heterogeneity and firm performance and the time of the IPO, our results were consistent with our argument that group faultlines and TMT 100

13 heterogeneity have significant and opposite effects on long-term performance. The lack of a relationship between TMT heterogeneity and firm IPO performance was surprising. We expected that the popular press meta-narrative about the positive benefits of diversity in the executive team and the generally positive empirical results found in the literature (e.g. Certo et al., 2006) would have a positive impact on the value placed on IPO firms by institutional investors or retail investors or both. We were unable to find any results consistent with this idea. Our statistical analyses were not marginally significant or even close. Our results suggest that heterogeneity may not be used by investors when they calculate firm value and whether to invest in a firm. Considering that, in our analyses, TMT heterogeneity is positively associated with better long-term firm performance, investors might want to consider TMT heterogeneity as part of their calculations of firm value at the time of the IPO, but this depends on whether the investor is focusing on short-term or long-term results. Our analysis does not provide an analysis of when heterogeneity may begin to have a significant effect on firm performance in the years after the IPO. Our research makes important contributions to both the Group Faultlines literature and the Upper Echelons literature. Our results support the argument that faultlines occur with top management teams. To our knowledge, this is the first empirical examination of the faultlines concept within entrepreneurial TMTs and IPO firms. This suggests that faultlines, and the factional groups that develop, appear to be relevant to rapidly growing firms going through the restructuring process necessary to prepare the firm for an IPO (Martens, 2004). This context is an important addition to the small but expanding group faultlines literature. To our knowledge, this is only the third study that examined faultlines in groups of executives, and the first to examine within-firm executive teams, and outside of the joint-venture context (Hambrick et al., 2001; Li & Hambrick, 2005). The addition of the group faultlines concept is an important contribution to the upper echelons literature. Although we open a crack in the black box of TMT demographic diversity (Lawrence, 1997), we make substantial inferential leaps from the existence of higher levels of faultlines to conflict in the IPO firm management team to poor long-term performance. The conceptual and empirical connection between strong faultlines, group conflict, and group performance is supported by the available research (Bezrukova, Thatcher, & Jehn, In Press; Lau & Murnighan, 2005) but it has not yet been demonstrated within the context of this study. The group faultlines calculation used, fau, is a measure of a potential faultline. We do not know in our data whether any factional subgroups (Li & Hambrick, 2005) actually developed exactly along the strongest faultline found in each TMT. Even if the factional groups did form exactly along the strongest faultline found in our data, we do not know whether the existence of these factional groups had a significant and negative impact on firm performance. Addressing these limitations requires longitudinal research involving direct contact with top management teams. Future Research. As we note earlier in the paper, a significant amount of research on group diversity, particularly research in upper echelons theory, has focused on demographic factors when examining the effects of heterogeneity on top management teams or boards of directors (e.g. Westphal & Zajac, 1995). However, recent research in the group dynamics literature suggests that there are limits to the utility of examining only demographic heterogeneity. Harrison et al. (1998) argue that demographic diversity is surface-level and that surface level diversity influences group dynamics for only a limited time after group formation. After multiple interactions, deep-level diversity becomes more influential in shaping group dynamics. While surface-level diversity is defined by observable demographic characteristics, deep-level diversity is defined by the dispositional and attitudinal characteristics among the members in the group. TMTs in existing companies, especially publicly-traded firms, have likely engaged in multiple interactions over a period of time within the firm and, in a small corporate community, outside the focal firm. As such, research on the group dynamics of TMTs should include an examination of both surface and deep-level heterogeneity. Direct measures of the underlying psychological processes and connecting them with demographics characteristics are needed to make significant advances in Upper Echelons theory. 101