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Reasons for Financing R&D Using the SWORD Structure A Thesis Submitted to the Faculty of Drexel University By Alexandra Kleanthis Theodossiou in partial fulfillment of the requirements for the degree of Doctor of Philosophy January 2007 ii iii Dedications To my parents Kleanthi and Anna For teaching me what no school or teacher can teach, To my children Theophani, Aristoniki and Anna Maria For making every moment special To the one I never held I am always thinking about you, you are not forgotten iv Acknowledgements A number of individuals have contributed to this dissertation. I particularly thank my thesis advisor, dr. Samuel S. Szewczyk for his continuous support and guidance. He provided new directions and ideas and structure to the dissertation. I would have not been able to finish without his expert advice and for that I am very grateful to him. I also want to thank Dr. Zaher Zantout for keeping the standards high. I have learned quite a lot from him through the development of the dissertation and his efforts are greatly appreciated. I owe a debt of gratitude to Dr. Michael Gombola for pointing new directions for my topic. Although they seemed impossible to execute, they made the dissertation so much more interesting. I also want to thank Dr. Jacqueline Garner and Dr. Nandini Chandar for their support. Finally I owe to acknowledge one more person, Maria Myers, the finance department secretary. She has been very supportive throughout the dissertation process and I thank her for that. v Table of Contents LIST OF TABLES.........................................................................................................vi LIST OF FIGURES .................................................................................................... vii ABSTRACT...................................................................................................................ix CHAPTER 1. INTRODUCTION ...................................................................................1 CHAPTER 2. FINANCIAL ENGINEERING USING THE SWORD CORPORATION AND R&D LP STRUCTURES................................10 2.1 The SWORD Corporation......................................................................10 2.2 The SWORD R&D LP Structure...........................................................15 CHAPTER 3. ACCOUNTING TREATMENT OF THE SWORD STRUCTURE......17 CHAPTER 4. HYPOTHESES......................................................................................20 4.1 The earnings management hypothesis ...................................................20 4.2 The “debt overhang” and “debt insurance” problems hypothesis .........22 4.3 Information asymmetries hypothesis .....................................................24 4.4 Separating assets of different risk classes hypothesis............................26 4.5 Sequential financing hypothesis ............................................................27 CHAPTER 5. METHODOLOGY ...............................................................................31 5.1 Tests for earnings management .............................................................31 5.2 Tests for the “debt overhang” and “debt insurance” problems hypothesis ................................................................................................................36 5.3 Tests for the information asymmetries hypothesis ................................38 5.4 Tests for the separation of assets of different risk classes hypothesis ...39 5.5 Tests for the sequential financing hypothesis ........................................41 CHAPTER 6. SAMPLE DESCRIPTION......................................................................43 CHAPTER 7. EMPIRICAL RESULTS ........................................................................62 CHAPTER 8. SUMMARY AND CONCLUDING REMARKS .................................74 VITA vi List of Tables 1. Description of the sample research and development programs that were financed through the SWORD structure............................................................86 2. Chronological distribution and the method of issuance of the sample SWORD securities ............................................................................................................95 3. Industry classification of the SWORD sample by the 1987 SIC code ..............96 4. Descriptive statistics of the research and development companies forming SWORD entities.................................................................................................97 5.a The SWORD forming companies and their R&D intensity matching sample ..99 5.b Industry and R&D intensity adjusted descriptive statistics of the research and development companies forming SWORD entities.........................................102 6.a Industry mean adjusted descriptive statistics of the research and development companies forming SWORD entities...............................................................104 6.b Industry median adjusted descriptive statistics of the research and development companies forming SWORD entities...............................................................105 7. Description of the sample research and development programs that were financed through the offering/placement of common stock and warrants.....107 8. Chronological distribution and the method of issuance of the offering or/placement of common stock and warrants sample to finance R&D programs ..........................................................................................................................109 9. Industry classification of the common stock and warrants offerings/placements sample by the 1987 SIC code...........................................................................110 10. Description of the sample research and development programs which were financed through the offering/placement of common stock ...........................111 11. Chronological distribution and the method of issuance of the offering /placement of common stock sample to finance R&D programs ...................113 12. Industry classification of the common stock offerings/placements sample to finance R&D programs by the 1987 SIC code ................................................114 vii 13. Descriptive statistics and comparisons of the gross proceeds raised through the SWORD structure, stock and warrant or stock only offerings to finance R&D ..........................................................................................................................115 14.a Short-term event study for the SWORD formation announcements ...............117 14.b Short-term event study for the final decision announcements.........................119 15. Pre and post-announcement average abnormal buy and hold stock returns ....120 16. Pre and post SWORD formation announcement long term stock price performance .....................................................................................................122 17.a The impact of a SWORD entity on the parent company’s consolidated income statement during the years it pays revenues to the parent company................125 17.b Cumulative impact of the SWORD entities on the parent company’s consolidated income statement during the years they pay revenues to the parent company................................................................................................128 18.a Descriptive statistics and comparison of the information asymmetries proxies between the SWORD companies and their matching samples........................129 18.b Level of information asymmetries in the year prior to and in the year after the announcement for the sample companies ........................................................131 19. Changes in post-event risk...............................................................................133 20. Delisting codes, reasons and number of delisted companies for the SWORD sample and its R&D matching sample for 5 years after the year of a SWORD formation..........................................................................................................133 21. Delisting codes, reasons and number of delisted companies for the SWORD sample and its R&D matching sample for 5 years after the year of a SWORD formation..........................................................................................................135 viii List of Figures 1. The corporation form of the SWORD financing arrangement ..........................84 2. The R&D LP form of the SWORD financing arrangement ..............................85 ix Abstract Reasons for Financing R&D Using the SWORD Structure Alexandra K. Theodossiou Samuel H. Szewczyk, Ph.D Several companies in the science and technology-based industries used the SWORD structure to finance some of their R&D programs. Yet, there is no clear rationale or evidence that this structure is improves welfare. This study explores and/or develops 5 testable hypotheses pertaining to the reason(s) some firms use the SWORD structure. The five hypotheses are (1) Earnings management hypothesis; (2) Debt overhang/insurance hypothesis; (3) Separation of assets of different risk classes hypothesis; (4) Information asymmetries hypothesis; and (5) Sequential investment problem hypothesis. The final sample consists of 41 companies making 66 SWORD announcements. Companies that form SWORD structures are young, high growth and small capitalization companies that operate mainly in science and technology based industries. They have the same leverage ratios as the average company
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