Why Do Companies Go Public? [the Pros and Cons of an IPO]

What is an IPO?

An initial public offering (IPO), sometimes named stock market launch, is basically the process of a privately-owned company going public for the first time by selling securities or shares to institutional investors and retail investors in the primary market. A company that announces an IPO and decides to issue securities to the public is described as the issuer. To do an IPO, a company needs underwriters, usually investment banks, who underwrite the whole process and arrange for the shares listing.

As the owners of the firm relinquish part of their company ownership to stockholders, the company’s shares can be traded in the open market, and as a result, the firm becomes a publicly traded company. 

The main reason why a privately held company does an IPO is to raise funds to accelerate its development.

What companies go public?

According to EY, the following companies usually decide to go public through an IPO:

• High-growth companies (to fund growth, innovation, acquisitions, internationalization)
• Private equity (PE) and venture capital (VC) owners (to exit and to further fund growth of portfolio companies)
• Scale-up companies (to effectively attract talent and to incentivize management)
• Conglomerates (IPO as the partial or full exit of business units and transaction to carve out)
• Family business — the company (to create the succession plan by separating ownership and management 
• Family business — the owner (to better manage succession and to diversify wealth) 
• State-owned entities (to privatize)

Why do companies go public?

Even though going public generates a lot of costs, companies still decide to do an IPO for a number of different reasons. 

• Raising capital 

Companies usually go public to “raise capital and broaden opportunities for future access to capital”, according to the SEC. A regular initial public offering usually raises a lot of capital that a company doesn’t need to pay back and can decide how to use it. 

Raised cash may be used to fund research and development, meet working capital needs, clear existing debt, build new facilities and buy new equipment, or acquire other businesses. Additional funds can be also used to buy holdings from investors and executives. What’s more, in future mergers and acquisitions, publicly traded stock may be used as transaction consideration, according to Deloitte. In large part, initial public offerings usually bring about $100 million to $200million, but some strong brands can raise bewildering amounts. Let’s have a look at the biggest IPOs in history:

• Extensive opportunities for future access to capital

In case of further financing needs, publicly-traded companies have the extended ability to gain capital in the future. When their stock performs well, they can issue additional stock on profitable terms.

• Lower cost of capital

Unlike bank loans or VC funding, capital gained through IPOs is relatively cheap. Due to a large pool of investors, high volume in the stock, companies going public can acquire capital from the public markets at significantly lower transaction costs.  

• Higher liquidity

Going public provides companies with high liquidity of their stock. Founders, management, investors, venture capitalists, and employees holding company stocks can basically sell them whenever they need to, provided that they obey applicable laws and regulations. 

Note that there is a restriction named an IPO lock-up period that prevents insiders from selling shares for a specific amount of time after the IPO. Although it usually ranges from 90 to 180 days, in the case of special purpose acquisition companies (SPACs), this time span is longer, typically from 180 days to one year.  

• Less dilution

Once companies are ready to go public, they can set a higher price for their shares through an IPO than through a private placement. That is to say, they can keep more stakes in the company to accumulate the same amount of funding.

• Exit strategy

Private companies which have managed to attract investors such as private equity firms or venture capitalists are seeking to increase liquidity by going public since such shareholders expect to withdraw their funds within a specified time span, usually less than 10 years. By issuing stock in the primary market, companies secure their major sponsors the ability to freely sell their shareholdings in an open market.  

• Enhanced brand recognition, visibility, and prestige

Going public generates a lot of publicity and media coverage of the financial markets which significantly enhances the company’s visibility, increases brand recognition and prestige. Due to the media and analysts’ interest, the company’s performance and financial results will be constantly in the spotlight. By comparing the company to competitors, broker-dealers will analyze the company’s financial performance to set earning expectations which also largely increases its visibility. 

• Enhanced credibility with business partners

As publicly traded companies need to provide periodic financial reports and meet stringent compliance requirements, they are perceived to be a stable and trustworthy business partner of prime importance by customers, investors, and suppliers. Primarily, it is critical for companies that focus on landing contracts with big companies such as Amazon, Apple, or IBM since they may feel more confident while entering into a relationship with a public company.

• Improved ability to attract and retain valuable employees

To attract and retain talented people, public companies can make incentive compensation plans based on stock options. By acquiring stock, the personnel have a chance to take part in the company’s success. Additionally, it may motivate them to be more engaged in work and view the company in the long term. So without increasing cash compensation, public companies have a higher opportunity to get the highest-potential people on board than private companies.  

• Higher net worth

An initial public offering determines the value of company shares and its market cap, as a result, the pre-IPO stockholders learn how much their shares are worth. Even if they don’t cash their stocks in the IPO, for the most part, their net worth will be higher and from that point on it will be set by the market. As publicly traded shares have high liquidity and can be sold at any time (excluding IPO lock-up period) so it is easier for stockholders to plan their finances.  

What are the cons of going public?

Despite many advantages, going public has also some potential drawbacks that should be analyzed thoroughly prior to an IPO.

• High costs

Going public usually entails substantial costs not only initially but also on a continuing basis. The largest cost for a pre-IPO company is the underwriters’ commission or discount which is mainly determined by the size of the offering or the standard price for offerings of similar complexity and size. Aside from the underwriters' commission, the company needs to bear hefty out-of-pocket costs, mainly for accounting, legal, audit fees, and printing. Moreover, each pre-IPO company must expect essential ongoing expenses related to the formal obligations such as periodic public reporting, independent directors’ fees, or D&O liability insurance.   

• Intensified financial and business transparency 

Unlike privately owned companies, listed companies are under increased public scrutiny. Their financial, tax, and accounting operations, and other business information are transparent and need to be disclosed quarterly due to requirements imposed on publicly held corporations. The company becomes entirely transparent since all confidential information such as the company’s sales and profits or executive information concerning compensation of its officers and directors is required to be divulged and reported to the SEC and the public on an ongoing basis, not only on an IPO date. 

• Increased management requirements

Executives in publicly traded corporations have more responsibilities as they need to not only be engaged in drawing up and certifying financial reports but also be accessible to shareholders, analysts, brokers, and the press. Increased number of obligations may distract top management’s attention away from operating the business which may result in smaller company’s growth. 

• Increased external and internal pressures

Whenever public company’s profits or sales diverge from analyst forecasts or established trends, shareholders may become timid and sell their stock which will drag down its price. Although a decreased stock price has no direct financial influence on a company, it can impact company's goodwill or employee compensation. In the long run, a low stock price may affect the profitability and even decrease potential proceeds from subsequent offerings. Furthermore, executives, pressured to drive the stock price higher and higher, may tend to focus on short term success instead of long-term strategy and development.   

• Continuous reporting requirements

Once a privately held company becomes a publicly traded company, it is required by law to report detailed financial and operating results to stockholders and the Securities and Exchange Commission (SEC). Public companies are subject to disclosure laws and regulations which force them to make financial condition, management compensation, operating results, basically the whole business model available to the public and the SEC. Publicly held companies must issue unaudited financial statements, such as income statements, balance sheets, and cash flow statements, and file them quarterly with the SEC. Moreover, they also need to draw up two annual reports, one for stockholders and one for the SEC. 

• Higher risk of losing control 

Apart from reporting obligations, every public company is required to elect a governing body called a board of directors consisting of independent directors who represent shareholders’ interests and set policies for corporate management and supervision. Generally, issuing shares to the public dilutes founders’ ownership and decreases their level of control over the company. In extreme cases, a board of directors may strip founders of their roles as executives or even fire them, what happened with Steve Jobs in 1985.

• Greater legal responsibility

Officers and directors of publicly traded companies experience greater legal exposure to shareholders litigations. As directors’ or officers’ duty is to thoughtfully represent shareholders’ interests, they are constantly under close scrutiny of potential stockholder plaintiffs and their lawyers. While performing corporate functions, public company’s executives need to fulfill three primary duties: a duty of care, duty of loyalty and duty of obedience. Any violations of those duties may result in a lawsuit against top management filed by dissatisfied stockholders. 

• Corporate governance requirements

In response to the corporate scandals (i.e. Enron and Worldcom), the Sarbanes-Oxley Act (SOX), passed in 2002, imposed significant corporate governance requirements on publicly traded companies. Its goal is to eliminate corporate fraud and increase public investors’ confidence in public companies. The act impacted profoundly corporate governance in the U.S. by enforcing new requirements on officers, directors, auditors, and counsels. According to the Sarbanes-Oxley Act, officers and directors are personally responsible for the accuracy of financial reports.

• Change in organizational culture

Going public influences the company’s corporate culture that often becomes more formal and less flexible due to the growing number of employees, more legal requirements, and heightened accountability to shareholders. 

Conclusion

Even though going public is a long, expensive, and complicated process, companies that intend to sell shares to the public notice more advantages of an initial public offering than disadvantages and perceive it as a strategic option to funding growth and future development. However, only companies which are well-prepared and fully aware of the pros and cons of going public can take advantage of the IPO window of opportunity.

Sources:

Strategies for Going Public, Fifth Edition, Deloitte

High-Profit IPO Strategies - Finding Breakout IPOs for Investors and Traders, Tom Taulli