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Scholars and practitioners have long theorized that by penalizing firms with unattractive governance features, the stock market incentivizes firms to adopt the optimal governance structure at their initial public offerings (IPOs). But the theory does not seem to match with practice. Not only do many IPO firms offer putatively suboptimal governance arrangements, such as staggered boards and dual class structures, these arrangements have been gaining popularity among IPO firms. This paper argues that the IPO market is unlikely to provide the necessary discipline to companies to adopt the optimal governance package. In particular, when the optimal governance package differs across firms and there is an informational gap between the firms and the outside investors, the IPO market cannot accurately price governance provisions, and many firms will adopt a suboptimal governance structure. After presenting the baseline thesis, the paper examines various private ordering and regulatory mechanisms that could mitigate this market failure, such as verification using a costly gatekeeper, reliance on internal capital markets, deliberate underpricing, and post-IPO liability. The paper also presents various positive and normative implications, such as empirical predictions as to when we may expect to observe better pricing of governance regimes and the proposal over sunset provisions on dual class stock structure that convert dual-class to single-class stock after the IPO.

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