Economic Modelling 78 (2019) 40–46

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Economic Modelling
journal homepage: www.journals.elsevier.com/economic-modelling

The impact of pre-IPO performance pressure on research and development

investments of an IPO firm: Evidence from China☆
Mingshan Zhou a, Dacheng Xiao b, Kam C. Chan c, d, *, Hung-Gay Fung e
a
Southwestern University of Finance and Economics, Chengdu, China
b
China Securities Co. Ltd, China
c
Fuzhou University of International Studies and Trade, Fuzhou, China
d
Gordon Ford College of Business, Western Kentucky University, Bowling Green, KY 42101, USA
e
College of Business Administration, University of Missouri-St. Louis, St. Louis, MO 63121, USA

A R T I C L E I N F O A B S T R A C T

JEL code: We derive a simple model to show that pre-IPO performance pressure has a negative impact on an IPO applicant's
G0 research and development investments. The findings from the Chinese IPOs in the growth enterprise market
Keywords: (GEM) are consistent with the model's predictions. Further analysis suggests that when the time to listing is
IPO shorter, the adverse impact of performance pressure on R&D investments is stronger. While the objective of the
Performance pressure GEM is to encourage innovative firms to raise new capital via IPOs to enhance their innovations in the future, the
Time to listing
cutting of R&D investments to enhance the probability of receiving IPO approval defeats the purpose. Our
Growth and enterprise market
findings suggest that it may be useful for a regulatory authority to consider multi-dimensional criteria in IPO
approvals for GEMs instead of heavily relying on the pre-IPO performance to sustain a healthy IPO market and
innovation activities of a country.

1. Introduction window-dress firms' performance and smooth their IPO applications. In

An initial public offering (IPO) is a desired goal and important
milestone for a private firm to raise external capital for future expansions
and operations. Capital formation by IPOs, particularly for firms on the
growth enterprise market (GEM), which primarily promotes advanced
technology and innovations, would likely create more firm innovations
and spillovers, leading to higher economic growth of a country (Mas-Tur
et al., 2015; Ferreira et al., 2017; Bournakis et al., 2018).
The quest for an IPO implies that a firm is under pressure to meet or
exceed the listing requirements for regulatory approval, which may have
unintended consequences as there are limited quotas imposed in the IPO
listing. Firms often take actions to fulfill the listing requirements by
managing their earnings to make the firms look good. Aharony et al.
(1993) document widespread earnings management among IPO firms in
their pre-IPOs to meet specific earnings requirements. These authors
attribute the findings to managers' opportunistic behaviors to
addition to earnings management, other potential manipulations by IPO
firms in the pre-IPO process are underexplored in the literature.
For young firms that aim to go public on the GEM, managing research
and development (R&D) investments is even more convenient and crit-
ical than other items compared to listing in a main board. Firms on the
GEM are generally smaller and younger and heavily rely on innovations
that are implicit in the policy objectives of the GEM than those on a main
board. R&D investments play a crucial role in the future success of young
firms post-IPOs (Guo and Zhou, 2016). Yet, few studies examine how the
performance pressure (i.e., pressure arising from the need to perform) in
pre-IPOs affects their R&D investments.
The objective of this paper is to examine the impact of the pre-IPO
performance pressure on a firm's R&D investments. On one hand, an
IPO firm, due to performance pressure, may choose to reduce its R&D
investments to boost its short-term earnings in pre-IPO to increase its
chance to receive regulatory approval. However, a low R&D investment

☆
We acknowledge the helpful comments from two anonymous reviewers and the editor (Professor Mallick). Zhou acknowledges the financial support from the
National Science Foundation of China (No. 71572151). The usual caveats apply.
* Corresponding author. Fuzhou University of International Studies and Trade, Fuzhou, China.
E-mail addresses: zhoumingshan@swufe.edu.cn (M. Zhou), xiaodacheng@csc.com.cn (D. Xiao), Johnny.chan@wku.edu (K.C. Chan), fungh@msx.umsl.edu
(H.-G. Fung).

https://doi.org/10.1016/j.econmod.2018.09.013
Received 25 April 2018; Received in revised form 1 August 2018; Accepted 9 September 2018
Available online 10 September 2018
0264-9993/© 2018 Elsevier B.V. All rights reserved.
M. Zhou et al.
level threatens the firm's post-IPO performance or even survival in the
long-term (Guo and Zhou, 2016). We expect the threats in the post-IPO
performance will be even stronger for firms on the GEM. Therefore, it is
an interesting research question whether an IPO firm chooses to cut
R&D investments in pre-IPO or keeps the R&D investments intact for a
better performance in post-IPO. We focus on the R&D investments of a
firm because they are a critical inputs for innovation, which play a
critical role in the success of the firm post-IPO and to the economy
(Ferreira et al., 2017; Mas-Tur et al., 2015; Fleming and Sorenson,
2004).
We use a sample of Chinese IPOs on the GEM in our examination.
China provides a good environment for our study. Since the launching of
its stock markets in the early 1990s, China has had a large volume of
IPOs to enhance capital formation. In particular, China encourages
young and innovative firms to list on the GEM in recent years. These
young firms are acutely confronted with the decision of cutting their
R&D investments due to the pre-IPO performance pressure or to
continue their R&D investments for better post-IPO prospects. The
analysis enables us to better understand how young and innovative firms
make tough decisions on their R&D investments during the IPO appli-
cation process.
Using a simple theoretical model of IPOs on the GEM and empirical
testing of the model predictions with data from 2010 to 2016, we offer
three findings. First, our model suggests that IPO firms tend to cut R&D
investments to window dress their probability to receive IPO approval
instead of maintaining R&D investments for future success. We note that
our model does not have country-specific elements. Thus, the theoretical
predictions apply to all markets, not only the Chinese market.
Second, after accounting for several control factors, we document
that, consistent with our model's prediction, the pre-IPO performance
pressure (or moving the IPO listing requirement higher as an alternative
way of raising the pre-IPO performance pressure) has an adverse impact
on R&D investments.
Third, we find that when the time to listing is shorter, the adverse
impact of the performance pressure on R&D investments is stronger.
Thus, while the objective of the GEM is to encourage innovative firms to
raise new capital via IPOs to enhance their innovations in the future,
cutting of R&D investments to enhance the probability of receiving IPO
approval defeats the purpose.
Our study contributes to the literature in two ways. First, we provide a
theoretical model to predict the adverse impact of the pre-IPO perfor-
mance pressure on R&D investments. Our empirical results confirm the
model's prediction. Thus, our study enriches our understanding on how
pre-IPO operations, such as R&D investments, are affected by the IPO
approval requirements. To the best of our knowledge, our study is the
first to study how an IPO firm manipulates its operations (R&D in-
vestments) pre-IPO beyond earnings management. We also show that
when an IPO firm has a shorter time to the listing date, the adverse
impact of the performance pressure on R&D investments is magnified.
Second, we show that pre-IPO firms on the GEM choose to reduce
R&D investments to window dress their performance. R&D investments
are key to these high-tech firms succeeding in the long run. Cutting
R&D investments implies a loss in the competitiveness of these firms.
Thus, the “do-anything” strategy to enhance IPO firms' probability to
receive approval may not help these young IPO firms in their post-IPO
performance and long-term survival (Guo and Zhou, 2016). While our
study uses Chinese data, our theoretical model and empirical findings
are applicable to other markets, especially those with GEMs. As to the
policy implication, it may be useful for a regulatory authority to
consider multi-dimensional criteria in IPO approvals for GEMs instead
of heavily relying on the pre-IPO performance to sustain a healthy IPO
market and innovation activities of a country. A multi-dimensional
criteria approach for IPO regulatory approvals can mitigate the
opportunistic behaviors of cutting R&D investments in the IPO appli-
cations and provide for the healthy economic development of an
economy.
41
Economic Modelling 78 (2019) 40–46
2. Background and literature review
2.1. Background
Recognizing the need for innovation to enhance its economic devel-
opment, the Chinese government began to consider establishing a GEM in
1999. The objective of a GEM is to encourage young and innovative firms
to go public in raising new capital for further development. After 10 years
of evaluation, the Chinese GEM was officially launched in 2009 in the
Shenzhen Stock Exchange, and it is officially called ChiNext.1 Initially,
there were 28 firms listed in the Chinese GEM in 2009, which rose to 602
firms in the beginning of 2017. In terms of the funds raised, the funds rose
from approximately RMB 155 billion in 2009 to approximately RMB 5.3
trillion in early 2017. To maintain an orderly market, the China Securities
Regulatory Commission (CSRC), the watch dog of the securities market, is
charged with the approval of IPO applications. While there are several
listing criteria in the Chinese GEM market,2 CSRC primarily uses pre-IPO
firms' earnings as the most important criterion in making approval de-
cisions. According to the “the Measures on the Administration of Initial
Public Offerings and Listings of Shares on the ChiNext” in 2015, an IPO
applicant needs to have the following: (1) a minimum of positive earnings
in the two most recent years with cumulative earnings of at least RMB10
million or (2) RMB 50 million positive earnings in the most recent year.
In reality, just meeting the minimum earnings requirement does not
suffice for regulatory IPO approval. For instance, in 2016, among all of
the new IPO firms approved on the GEM, the lowest earnings level was
approximately RMB 46 million by Hangzhou Anysoft IT Co. Ltd (ticker
no. 300571), which was four and a half times the minimum earnings
requirement (RMB 10 million). Hence, it would not be a surprise that IPO
applicants manipulate their earnings to boost their chance of IPO
approval, especially when the published minimum earnings requirement
is not indicative. Several studies, such as Aharony et al. (1993) and Teoh
et al. (1998), confirm the widespread earnings manipulation phenome-
non in pre-IPOs. Engaging in earnings management is not without limits
as excessive earnings management raises a red-flag that will hurt a firm's
chance of IPO approval. Thus, a reasonable approach for pre-IPO firms is
to cut their real expenses to boost earnings. Among all expenses, R&D
investments, which are a discretionary item, can immediately reduce
earnings. Thus, IPO firms have a strong temptation to cut R&D in-
vestments to boost current earnings.
2.2. Literature review
2.2.1. IPO-earnings management
To gain regulatory IPO approval, firms can use strategic assets to
avoid uncertainty and conflicts to exploit market imperfections to ach-
ieve the desired results (Amit and Schoemaker, 1993). When firms go
public to raise external capital, they need to satisfy the listing re-
quirements, which may vary across exchanges and countries. As a result,
these IPO firms will take certain actions that appear to fulfill the listing
requirement of earnings by manipulating their accounting information.
Naturally, IPO firms will likely manipulate their earnings in the periods
prior to taking their firms public. Earnings management is expected to be
less severe if there is better monitoring (Aharony et al., 1993) and these
firms are concerned with a subsequent poor long-term earnings perfor-
mance. Earnings management by IPO firms will also negatively affect the
1
For convenience and consistency with the literature, we continue to call it
GEM in this paper.
2
Some additional listing requirements include the following: (1) A minimum
of RMB 20 million in total assets; (2) after the IPO, the total share capital must
be at least RMB 30 million; and (3) a minimum of three years of operations.
There are also other criteria, such as operations, personnel, accounting, and
company organization. For more details, see http://www.szse.cn/main/en/
ListingatSZSE/ListingRequirements/ (accessed February 2018).
M. Zhou et al.
sentiment of institutional investors toward subscriptions of the IPO, their
bid prices, and final offer prices; therefore, institutional investors keenly
recognize earnings management by IPO issuing firms, thus resulting in a
lower offer price (Gao et al., 2017).
2.2.2. IPO R&D investments and their implications
R&D investments are expensive and are not mandatory. Firms
manipulate R&D investments to achieve different goals. We would expect
that CEOs would manage costly R&D investments to achieve a better
short-term performance that can potentially improve their compensation,
which in turn, is linked to firm performance (Cheng, 2004; Dechow and
Sloan, 1991). Reductions in R&D investments clearly reflect cost-benefit
tradeoffs to a CEO, who acts as an agent and demands better compen-
sation, and the shareholders of the firm, who want a higher market value
of the firm (Dechow and Sloan, 1991). If R&D investments can be
manipulated to boost the short-term earnings performance, the impli-
cation is whether IPO firms indeed boost earnings to satisfy the
short-term earnings target requirement of the IPO application.
It seems clear that R&D investments are an important input for
innovativeness that maintains a firm's market competitiveness (Greve,
2003). Thus, it is expected that the noted changes in R&D investments
have severe adverse consequences on the firm, in particular, and on the
economy, in general. At the firm level, R&D investments will likely lead
to an improved operating performance, followed by improved stock
prices or returns in the long-run (Eberhart et al., 2004; Chan et al., 2001).
Particularly, Guo and Zhou (2016) demonstrate that the innovation
capability is critical to contemporaneous stock performance and future
firm survival. The R&D investment intensity reduces IPO underpricing
and improves the long-term performance of IPO firms because in-
novations would reduce information asymmetry to investors (Heeley
et al., 2007; Guo et al., 2006). Addessi et al. (2014) derive a model
showing that R&D and innovation can enhance labor productivity.
Nemlioglu and Mallick (2017) document that better-managed firms
enhance the impact of innovation on firm performance.
At the macroeconomic level, increases in R&D investments would
likely provide greater innovations in a country and thus trigger higher
economic growth (Ferreira et al., 2017; Mas-Tur et al., 2015; Fleming and
Sorenson, 2004) and improved total factor productivity (Bournakis and
Mallick, 2018). Improved economic growth will certainly increase the
employment opportunities and living standards of the working class.
The results of the R&D investment literature have particularly
important implications for high-tech IPO firms that face performance
pressure. As R&D investments are costly, they will reduce current earn-
ings performance. Therefore, imposing more stringent regulations, such
as raising the IPO listing requirements, clearly affect firm behaviors and
the market (Ma et al., 2010) and motivates firms to manage R&D in-
vestments during the IPO application process. However, there is limited
research on R&D investments for IPO firms.
Jeon and Kim (2011) show that an IPO firm's R&D investments exert
positive effects on firm value, and in general, R&D investments and
capitalizing R&D expenses positively affect firm values in the Korean
stock market.
Overall, our paper is the first to examine the impact of the IPO
application process on R&D investments. Our results shed light on the
question of whether an IPO firm cuts R&D investments to boost earnings
listing requirements. The decision to cut R&D investments would illus-
trate an interesting tradeoff between successful IPO approval and losing
the firm's market value and competitiveness. Moreover, this action clearly
contradicts the intended goal of the government policy for the high-tech
firms listed on the GEM and is thus worthy of a closer examination.
3. The model
3.1. Base model
We propose a simple model to show the impact of performance
42
Economic Modelling 78 (2019) 40–46
pressure on R&D investments. The model has five assumptions.
A1: The IPO firm's shareholders are homogenous in their utility
functions. Without the loss of generality, the initial shareholders have a
common quadratic utility function based on the inputs that are related to
the probability of receiving IPO approval (P) and the future performance
(F) of the firm. The utility functions from the probability of IPO approval
and future performance are additive. The utilities are positively corre-
lated with the inputs related to the probability of receiving approval and
future performance. That is,
U ¼ UðPÞ þ UðFÞ (1)
where U is the utility of the initial shareholders, U(P) ¼ -P2 þ βP;
0 P < β/2, and U(f) ¼ -F2 þ βF; 0 F < β/2; and β > 0.
A2: The probability of receiving approval is positively correlated with
the difference between an IPO firm's after-taxed earnings (I) and the
regulatory authority's minimum IPO required earnings (M). That is, if
(I  M) is high, the firm has a higher probability of receiving IPO
approval. To factor in the impact of R&D investments (R), we define EBR
as the earnings after interest and taxes without R. We consider the fact
that many countries, such as China, provide tax incentives to firms for
R&D investments. Without a loss of generality, we assume that R&D
investments are fully tax deductible.3 The after-tax earnings, I, can be
expressed as follows:
I ¼ EBR  ð1  τÞ*R (2)
where τ is the corporate income tax rate. Upon simplification, we have
I ¼ EBR  R þ τ*R, where τ*R is the present value of the tax-shield on
R&D investments.
To simplify the model, we assume the inputs related to the probability
function of receiving IPO approval, P, is given as follows:
P¼MI (3)
That is, a large difference in (M  I) means a high performance
pressure for the firm to receive IPO approval, or vice versa.
A3: The future performance (F) of the firm is a positive and linear
function of R (research and development investments), thus implying
that R provides long-term benefits to the firm in terms of profitability and
competitive advantages. That is,
F ¼ q*R; q > 0: (4)
A4: EBR is exogenous to the model.
A5: The IPO firm's initial shareholders maximize their utility.
Based on five assumptions of the model, we obtain the following two
propositions:
Proposition 1. An IPO firm cuts R&D investments when facing perfor-
mance pressure pre-IPO, and
Proposition 2. An IPO firm cuts R&D investments when the regulatory
authority raises the listing requirement with respect to performance.
Proof. See Appendix A.
We can test the first proposition by examining the impact of perfor-
mance pressure in the pre-IPO period on the firm's R&D investments. In
the second proposition, the CSRC has not officially raised the listing
performance requirement since the establishment of the GEM in 2009.
Hence, it cannot be directly tested and can only be indirectly inferred. All
else being equal, raising the listing performance requirement is only an
alternative way of raising the performance pressure on an IPO firm pre-
IPO. If Proposition 1 is empirically valid, Proposition 2 is also valid. Using
a general model without the restrictive assumptions of the quadratic
3
The Chinese government allows for 150% tax deductions of R&D in-
vestments. Other countries may have similar arrangements.
M. Zhou et al.
utility function, we obtain the same two propositions, which can be
tested empirically. See Appendix B for the details.
3.2. Extensions
In addition to the performance pressure, we contend that the time to
listing (TTL) moderates the performance pressure on R&D investments.
Proposition 1 in the model does not incorporate the impact of TTL. Based
on intuition, with all else being equal, when TTL is small, the IPO firm has
less time and room to maneuver its performance in preparation for its IPO
application. Thus, the pressure to cut R&D investments is stronger when
TTL is shorter. We consider TTL in our additional analyses when exam-
ining the validity of our model.
4. Data and methods
4.1. Data
The GEM began trading in 2009. With the need to have pre-IPO data,
we focus on IPOs from 2010 to 2016. China suspended its IPO applica-
tions in November 2012 and reopened them in January 2014. Hence,
those listed in early 2014 were approved in 2012. Thus, we use the
official CSRC IPO approval date, not the actual listing date, as our
reference date. The IPO application takes time, and thus, some IPO ap-
plicants have more pre-IPO financial statements available than others.
Therefore, we have an unbalanced panel of data. We have 453 IPOs in the
GEM. After deleting some firm-years with missing information in R&D
investments or control variables, our final sample has 1026 firm-years in
pre-IPOs.
4.2. Method
We use a multiple regression model to examine our two propositions.
The base model is as follows:
Ri;t ¼ β0 þ β1 *PPi;t þ Σβj CONTROLi;t þ εi;t
where R is the R&D investments, PP is the performance pressure, CON-
TROL is a set of control variables, and ε is a random error term. To ac-
count for firm size, we normalize R by total assets. We calculate PP as
follows:
0
0
PP ¼ M  EBR =M
EBR ¼ I þ ð1  1:5τÞ*R
where M0 is the implicit minimum listing requirement and EBR is the
after interest and taxes but before R&D investments earnings. Given that
all IPO firms' performances exceed the official minimum (M), it is not
useful to use the official M to calculate performance pressure. Hence, we
use M0 instead of M. While M0 is not directly observable, we proxy M0 as
the 10th percentile of the average of the previous three years earnings4
for all of the successfully listed firms on the GEM in the current and
previous years.5 For instance, in 2016, we consider all of the approved
IPO firms in 2015 and 2016 and examine the average of their previous
three years of earnings. Then, we rank them from top to bottom and take
the 10th percentile firm's average three-year earnings as M0 . It is expected
that M0 is higher than the legal minimum listing requirement (M).
We modify Equations (2)–(7) to reflect the Chinese tax policy of
allowing firms to deduct 150% of R&D investments. With a given M0 ,
4
We use three years because the CSRC mandated IPO firms to disclose at least
three years of financial data in their pre-IPOs.
5 NPM
The conclusions do not change if we use the lower 5th, 15th, or 20th
percentiles.
Economic Modelling 78 (2019) 40–46
when PP is small (i.e., a large negative number), it means that the EBR of
a firm is large. Thus, the IPO applicant will face a lower performance
pressure.
The control variables include the following: firm size (SIZE), return on
assets (ROA), financial leverage (LEV), operating cash flows to total
revenue (OCF), net profit margin (NPM), and overseas revenue to total
revenue ratio (OB). The detail definitions of all of the variables are pre-
sented in Table 1.
5. Results and discussions
5.1. Summary statistics
We present the summary statistics in Table 2. For R, the mean is
5.124, thus suggesting that a typical IPO firm has 5.124% of R&D in-
vestments relative to its total assets in all firm-years. In terms of perfor-
mance pressure, the average of PP is 2.321, thus suggesting that, on
average, an IPO firm is 232.1% above the implicit minimum listing
requirement. To provide graphical evidence, we plot the IPO firms'
average R and PP in t-4 to t-1 (where t is the IPO year) in Fig. 1. The
average R monotonically decreases from 5.6% in t-4 to 4.78% in t-1. For
the average PP, it exhibits a U-shape with a drop from t-4 to t-3, but
gradually reverses back the same level in t-1. Despite that PP does not
show monotonic decreases, it is higher when the firm is closer to the IPO
year. The graphical evidence provides preliminary evidence that a pre-
IPO firm cuts R&D investments and that the performance pressure is
higher when it is closer to the IPO year.
5.2. Base results
We present the regression results for the base model of Eq. (5), as
shown in column (1) of Table 3. The coefficient of the PP is 0.099, and it
is significant at the 1% level, suggesting that when a firm faces a high
performance pressure, it cuts its R&D investments. The coefficient of the
PP is also economically significant. When PP increases by one standard
(5) deviation (5.582), R will decrease by 0.145 standard deviation. The re-
sults are consistent with Proposition 1. The control variables, if signifi-
cant, carry the expected signs. For instance, the coefficients of SIZE and
NPM are negative, thus indicating that when a firm is large or when the
firm keeps its net profit margin high, its R&D investments are lower. By
contrast, when a firm has a high profitability (a high ROA), it can afford
to bear more R&D investments.
(6)
5.3. Additional results: impact of the time to the IPO listing date
(7)
To examine the moderating role of the time to the IPO listing date
(TTL), we modify Eq. (5) to factor in these variables as follows:
Table 1
Variable definitions. Table 1 provides the definitions of the major variables.
Variable Meaning Definitions
R R&D investments The ratio of R&D investments to total assets
R2 Alternative R&D The ratio of R&D investments to total sales
investments
PP Performance PP ¼ (M0  EBR)/M0 where EBR ¼ I þ (1-1.5τ)
pressure *R, M0 is the implicit minimum listing
requirement, τ is the corporate tax rate, and EBR
is the after tax earnings before R&D investments.
TTL Time to IPO listing Takes a value of 1 if the time is t-1 (t is the IPO
year) and zero otherwise
SIZE Firm size Natural logarithm of total assets
ROA Returns on assets Net earnings to total assets ratio
LEV Financial leverage Total liabilities to total assets ratio
OCF Operating cash flow Operating cash flow to total assets ratio
Net profit margin Net earnings to total revenue ratio
OB Overseas revenue Overseas revenue to total revenue ratio
43
M. Zhou et al. Economic Modelling 78 (2019) 40–46

Table 2 Table 3
Summary statistics. Table 2 presents the summary statistics of the major vari- The impact of performance pressure and time to listing on R&D in-
ables. The definitions are provided in Table 1. vestments. Table 3 presents the findings on the impacts of performance pressure
Unit N Mean Median Std dev.
(PP) and time to listing (TTL) on R&D investments (dependent variable). The
definitions are provided in Table 1. The t statistics are in parentheses. ***, **, and
R Percent 1026 5.124 4.044 3.802 * indicate 1%, 5%, and 10% significance, respectively.
R2 Percent 1026 6.227 4.916 4.216
PP Number 1026 2.321 1.456 5.582 (1) (2) (3)
TTL Indicator variable (1, 0) 1026 0.357 0.000 0.479 R R R
SIZE Natural logarithm of yuan 1026 19.625 19.584 0.649
ROA Percent 1026 18.315 15.842 10.501 PP 0.099*** 0.098*** 0.087***
LEV Percent 1026 38.572 37.768 15.765 (-2.710) (-2.660) (-2.838)
OCF Number 1026 0.125 0.114 0.108 SIZE 1.724*** 1.703*** 1.804***
NPM Number 1026 0.200 0.183 0.099 (-4.428) (-4.187) (-4.413)
OB Number 1026 0.133 0.007 0.225 ROA 0.145*** 0.145*** 0.140***
(5.645) (5.628) (5.490)
LEV 0.045*** 0.045*** 0.045***
(-4.711) (-4.659) (-4.646)
Ri; t ¼ δ0 þ δ1 *PPi;t þ δ2 *ðPPi;t *TTLi;t Þ þ δ3 *TTLi;t þ Σδj CONTROLi;t þ φi;t OCF 2.235 2.231 2.343
(8) (1.452) (1.452) (1.523)
NPM 13.409*** 13.422*** 13.273***
(-6.762) (-6.762) (-6.766)
where TTL is a (1, 0) indicator variable with a value of 1 if the IPO firm is
OB 0.093 0.088 0.084
within 1-year of the IPO approval date and zero otherwise. We expect δ1 (0.162) (0.154) (0.146)
to be negative and significant per Proposition 1. For δ2, we expect it to be TTL 0.077 0.301
negative and significant for PP*TTL. That is, conditional on the perfor- (-0.300) (-1.148)
mance pressure, when an IPO firm faces a tight time constraint, it cuts PP*TTL 0.095*
(-1.939)
more R&D investments. We expect that δ3 is either insignificant or Year Yes Yes Yes
negatively significant. Intercept 39.813*** 39.471*** 41.533***
For robustness, we run an additional Eq. (8) without PPi,t*TTLi,t. The (5.169) (4.951) (5.170)
results are presented in columns (2) and (3) of Table 3. As expected, the N 1026 1026 1026
R2 0.292 0.292 0.295
coefficients of PP in columns (2) and (3) are consistently positive and
significant at the 1% level, thus confirming the results in column (1).
More importantly, the coefficient of PP*TTL (the interaction term) is
negative and significant at the 10% level in column (3), thus suggesting investments.
that the marginal impact of having the pre-IPO firm in t-1 magnifies the
negative impact of PP in the pre-IPO on R&D investments. The co- 5.4. Robustness checks
efficients of TTL in columns (2) and (3) are not significant, thus indi-
cating that the adverse impact of TTL on the R&D investments is For the robustness of the base results and the moderating findings, we
conditional on PP. That is, an IPO firm only encountering a tight time use alternative measures of R&D investments and performance pressure.
window in its pre-IPO does not necessarily cut its R&D investments. If an Specifically, we use R2, which is a firm's R&D investments divided by its
IPO firm faces performance pressure and it is close to the approval time, total sales.
then the negative impact of TTL adds to the negative impact on R&D Table 4 presents the robustness checks results in columns (1) to (3).

Fig. 1. R&D investments (R) and performance pressure (PP) in the pre-IPO.

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M. Zhou et al. Economic Modelling 78 (2019) 40–46

Table 4 1% level. In column (3), the coefficient of PP*TTL is significant at the 5%

Robustness checks: Alternative measures of research and development level with the expected sign. Thus, using alternative measures of R&D
expense. Table 4 presents the findings on the impacts of performance pressure investments does not qualitatively change our earlier findings presented
(PP) and time to listing (TTL) on R&D investment. The definitions are provided in in Table 3.
Table 1. The t statistics are in parentheses. ***, **, and * indicate 1%, 5%, and
10% significance, respectively.
6. Summary
(1) (2) (3)

R2 R2 R2 IPOs are critical for firms, especially young and innovation ones, to
PP 0.117*** 0.117*** 0.103***
raise capital. The capital formation in IPOs contributes to the economic
(-2.808) (-2.784) (-3.023) development of an economy. The evolution of the stock market and ac-
SIZE 1.906*** 1.907*** 2.035*** celeration of the IPO market have propelled the fast economic growth of
(-4.455) (-4.296) (-4.563) China in recent years. To accommodate young and innovative firms,
ROA 0.057** 0.057** 0.064**
China introduced a GEM in 2009. Our study shows that, in theory and
(-2.209) (-2.198) (-2.381)
LEV 0.041*** 0.041*** 0.040*** evidence, the listing requirements lead to an unintended consequence of
(-3.558) (-3.517) (-3.504) lower R&D investments for IPO applicants in the Chinese GEM. The
OCF 1.506 1.506 1.647 adverse impact on R&D investments is magnified when the time to IPO
(0.931) (0.931) (1.014) application is shorter and conditional on the performance pressure. Our
NPM 10.458*** 10.459*** 10.647***
(4.241) (4.236) (4.302)
findings show that the cutting of R&D investments defeats the purpose of
OB 0.690 0.690 0.696 a GEM. Therefore, for government regulations (in the IPO approval) in
(-1.270) (-1.270) (-1.282) financial markets, while the policy intent is to protect investors and
TTL 0.004 0.279 promote economic development, it reduces the competitiveness of the
(0.012) (-0.866)
firms because they want to cut R&D to boost earnings to receive IPO
PP*TTL 0.121**
(-2.303) approval. The cutting of R&D investments hurt firms and the industry in
Year Yes Yes Yes the long run because it lowers the long-term profitability of the firms and
Intercept 43.504*** 43.521*** 46.131*** industry. These firms would not as competitive as they should be, thus
(5.152) (5.010) (5.268) leading to suboptimal resource allocations. Hence, for IPO approval, it
N 1026 1026 1026
would be useful for the regulatory authority to implement a multi-
R2 0.200 0.200 0.204
dimensional criteria approach, which can mitigate the situation of
being overly dependent on earnings and help to develop a healthy IPO
Using R2 as the dependent variable, the coefficient of PP is negative and market and the economic development of a country.
significant at the 1% level in column (1). In addition, in columns (2) to
(3), the coefficients of PP continue to be negative and significant at the

Appendix A. Proof for Propositions 1 and 2

Following assumptions A1 to A5, when we substitute Equations (2)–(4) into Equation (1), we have



U ¼  P2 þ βP þ  F 2 þ βF ¼ ½EBR  ðR  τ*RÞ  M2 þ β½EBR  ðR  τ*RÞ  M  ðq*RÞ2 þ βðq*RÞ (A1)

To maximize the utility in Eq. (5), the first order condition for optimum R&D investments (R*) is

2ð1  τÞðEBR  MÞ þ βq  βð1  τÞ

R* ¼ (A2)
2ð1  τÞ2 þ 2q2
To examine the pre-IPO performance pressure and regulatory minimum performance (the level of EBR and M), we obtain the first derivative of R*
with respect to EBR and M as follows:

∂R* ð1  τÞ
¼ >0 (A3)
∂EBR ð1  τÞ2 þ q2

and

∂ R* ð1  τÞ
¼  <0 (A4)
∂M ð1  τÞ2 þ q2
Since (1  τ) > 0 and [(1  τ) þ q2] > 0. Hence, according to Equation (A3), if an IPO firm faces performance pressure, i.e., EBR is dropping pre-IPO,
then the firm will cut its R&D investments, as suggested by Proposition 1. Similarly, according to Equation (8), if the regulatory authority raises the
listing performance (M is rising) pre-IPO, the firm will cut its R&D investments, as proposed by Proposition 2. It is easy to show that the second order
condition is met in Equation (A4). Q.E.D.

Appendix B. A Model with some general assumptions

Let us assume

UðPÞ ¼ f ðPÞ and UðFÞ ¼ gðFÞ (B1)

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M. Zhou et al. Economic Modelling 78 (2019) 40–46

where P ¼ M  I þ tR, and t ¼ (1  τ); F ¼ qR.

Assumptions:

(1) The first derivatives of f and g with respect to R are positive, thus implying a positive return to R. That is, f0 and g0 > 0.
(2) The second derivative is negative, thus denoting diminishing return of these functions with respect to R. That is, f00 < 0, and g00 < 0.
(3) The first derivative of F with M is negative. It is a reasonable assumption because when a regulator's target earnings requirement is higher, it
reduces the entrepreneur's utility due to lowering the chance of IPO approval.
(4) First derivative of F with respect I is positive, thus implying that higher earnings of the firm generate higher utility for the entrepreneur.

The first order condition to obtain an equilibrium R is to differentiate Eq. (B1). Then, we obtain the equilibrium by setting the first order condition to
zero:
0 0
f tþgq¼0 (B2)
Differentiating Eq. (B2) with respect to I yields the following:

dI dR dR
f 00 ð  1 Þ þ f 00 t 2 þ q2 g00 ¼ 0
dI dI dI
Rearranging the equation yields the following:

dR 

¼ f 00 t 2 f 00 þ q2 g00 > 0 (B3)
dI
Eq. (B3) is positive because f 00 < 0 while f00 and g00 are negative in the denominator of the equation, which is Proposition 1.
To analyze the relationship between equilibrium R and M, we utilize Eq. (B2) again. Differentiating the first order condition with respect to M yields\
0
df dR dR
t þ f 00 t2 : q2 g00 ¼0
dM dM dM
Rearranging the terms yields the following:
 0 
dR df

¼ t t2 f 00 þ q2 g00 < 0 (B4)
dM dM
As f00 and g00 are both negative while the first derivative of f0 with respect to M is negative as assumed earlier, Eq. (B4) is negative, thus confirming
Proposition 2. Q.E.D.

Appendix C. IPO approval rate in GEM

Appendix C presents the IPO approval rate in the Chinese GEM. China suspended IPOs from November 2012 to December 2013. Hence, we use the
2012 figures for 2013.

2010 2011 2012 2013 2014 2015

IPO applications 168 139 117 0 38 114

IPO approvals 143 113 91 0 33 103
IPO rejection rate 14.88% 18.71% 22.22% 22.22% 13.16% 9.65%

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