R&D Investment Decisions of IPO Firms and Long-Term Future Performance

Abstract

This paper links valuation of different accounting items to R&D investment decisions and investigates how suboptimal R&D choices during IPO are linked to future operating and market underperformance. For firms with substantial growth opportunities, accounting net income is a poor measure of the firm’s performance (Smith and Watts 1992). Therefore, other metrics such as R&D intensity are used by investors to evaluate firms’ performance. This leads to a coexistence of two strategies: 1) if earnings are the main value-driver firms tend to underinvest in R&D; and 2) if R&D expenditures are the main value-driver firms tend to overinvest in R&D. We show that the R&D investment decision varies systematically with cross-sectional characteristics: firms that are at the growth stage, unprofitable, or belong to science-driven industries are more likely to overinvest, while firms that are able to avoid losses by decreasing R&D expenditure are more likely to underinvest. Finally, we find that R&D overinvestment leads to future underperformance as evidenced by poor operating return on assets, lower product market share, higher frequency of delisting due to poor performance, and negative abnormal stock returns. While prior literature concentrates on R&D underinvestment as a tool of reporting higher net income, we demonstrate the existence of an alternative strategy used by many IPO firms – R&D overinvestment.

Keywords: Initial Public Offering; R&D Underinvestment; R&D Overinvestment; IPO R&D Management; IPO Earnings Management, Accounting