Pre-IPO dividend puzzle: Reaction to IPO underpricing or post-IPO lockup? Evidence from China

It remains a puzzle as to why firms pay cash dividends to initial investors prior to their initial public offerings (IPOs) while at the same time raising capital through the IPOs. Leveraging mandatory disclosure from three years of pre-IPO data in China, we examine two possible explanations for this puzzle: strategic reactions to IPO underpricing and post-IPO lockup. Our findings suggest that (1) when an IPO firm expects a large IPO underpricing, it pays more cash dividends pre-IPO, suggesting that initial shareholders view large IPO underpricing as undervaluing the market value of the firm's cash pre-IPO. (2) When an IPO firm pays more cash dividends pre-IPO, its initial shareholders unload fewer shares post-IPO after lockup expiration, suggesting that the initial shareholders receive “compensation” via cash dividends to ease their liquidity concern from post-IPO lockup. Both results support the proposed explanations. Additional analyses show that high cash dividend payouts pre-IPO are associated with fewer fixed assets, less investment in research and development, and poor performance post-IPO. These results indicate that cash dividends pre-IPO are not consistent with shareholder value maximization. Overall, pre-IPO cash dividends reflect a type II agency conflict in which initial shareholders seek private benefits at the expense of future shareholders.