Going public with an initial public offering (IPO) is a way to raise capital and issue shares to investors that will be tradable on a stock exchange. Transitioning from private company to public company has pros and cons that need weighing before starting the IPO process.
This article discusses the advantages and disadvantages of going public through an IPO from the company’s standpoint. It also addresses implications for the stakeholders, including venture capital or private equity firms and the IPO company’s management team, Board of Directors, and employees.
Advantages to Going Public with an IPO
Companies will raise substantial amounts of capital through an IPO and subsequent funding rounds to fund general corporate operations, growth opportunities, R&D, marketing, capital expenditures.
Gaining Higher Share Valuation
Shares that trade on a public stock exchange like New York Stock Exchange (NYSE) or Nasdaq have more liquidity than privately held shares. Company market cap valuation and the stock price is higher.
Funding for M&A Transactions
With a higher valuation, the company’s stock can be used to complete corporate M&A transactions using more cash raised or an exchange of fewer shares. Cash proceeds can be raised for M&A in an IPO or future stock offerings. Successful M&A translates to synergy and growth in corporate revenue and earnings.
Reducing Corporate Debt
Public companies may retire debt through the IPO or subsequent share offerings to reduce interest costs and improve cash flow and their debt to equity ratio.
Maintaining Corporate Identity and Becoming Better Known
If a company chooses an IPO as an exit strategy instead of being acquired by another company, it maintains its corporate name and status. This continuing nature of the corporation as a parent company and its name recognition may have meaning for the company founder.
Companies going through an IPO are more recognizable and gain the attention of potential customers and new strategic partners through press releases and financial media coverage. Public companies are more transparent than private companies because they need to disclose information, including financial statement results, publicly.
Attracting and Retaining Employees
Companies can attract certain types of employees having a lower risk tolerance with stock grants and public stock option plans. Current employees will be eligible for new stock options or discounted stock purchase plans.
Some employees prefer to work for larger public companies rather than startups, although entrepreneurial employees can gain higher stock rewards as early-stage pre-IPO investors.
Disadvantages to Going Public with an IPO
The IPO process is a lengthy and time-consuming one that may begin up to two years before an initial public offering in the public market.
The management team and Board of Directors for the IPO must be selected. Bylaws, other legal agreements, and financial statements must be cleaned up and audited. Systems must be ready. Historical and current quarterly financial information is needed. Stock exchange listing applications must be made. An SEC registration statement, including the prospectus, must be completed, then reviewed by attorneys and accounting professionals in the SEC’s Division of Corporate Finance. Their comments must be cleared for the registration statement to become effective. Presentations must be created and practiced with investor relations and IPO professionals. The company needs to learn to act like a public company and produce and analyze financial information equivalent to a public company. The company selects an investment banking firm as the lead underwriter. A roadshow is conducted. Valuation and demand are determined, the IPO share price is set, and shares are allocated through underwriting to IPO investors. Then shares of stock begin trading for resale in a stock market like Nasdaq or NYSE.
After the company goes public, time commitment from the CEO and CFO will still be required to address public company responsibilities, including regulatory filings including financial reporting, investor relations, and holding quarterly conference calls.
Distraction from Business and Missed Opportunities
When a pre-IPO company completes numerous required projects and holds meetings during the IPO process, employee workloads will expand beyond the regular job. Some tasks will not be completed, or mistakes will be made. It’s possible that the IPO process will result in an opportunity cost of missed growth opportunities Staffing levels will need to be increased to mitigate these risks.
Cost of Issuing Shares in an IPO
The investment banker syndicate serving as underwriters receives a hefty percentage-based underwriting fee for shares sold in the IPO. In 2017, Statista reported that IPO underwriting fees ranged from about 4% to 7% in the United States, varying by deal size. The substantial amount of capital raised by the IPO company mitigates this disadvantage because underwriting fees are deducted from IPO gross proceeds.
Managing for Short-Term Quarterly Results instead of Long-Term Goals
Public companies must have strategies to meet short-term revenue and profit (or loss) estimates instead of focusing just on long-term business plans. Missing financial estimates generally cause steep drops in the stock price. This short-term focus may be frustrating for company management.
Public Information Scrutiny
Private companies, used to keeping information confidential, need to prepare themselves for sharing financial reports and disclosure information with the public, including competitors. If publicly sharing information is a firmly held objection to going public, the company may decide against having an IPO.
Risk of Not Completing the IPO Process
Suppose capital markets are not conducive to completing an IPO. Then time spent and costs incurred by a company for Public Company Accounting Oversight Board (PCAOB)-compliant audits and services from consultants, prominent CPA and securities law firms can’t be justified if the company won’t get IPO proceeds.
Higher Weighted Average Cost of Capital
The cost of equity, determined using the capital asset pricing model (CAPM), is higher than the cost of debt. Raising new public equity will increase the company’s weighted average cost of capital (WACC). WACC is a hurdle rate for decision-making to evaluate capital expenditure projects expected to contribute to growth. This objection is offset by the substantial amount of capital that can be raised in an IPO.
How Does a Portfolio Company IPO Impact VC or PE Investors?
Venture capital (VC) firms and angel investors or private equity firms may be existing shareholders in the private company considering going public.
When a VC portfolio company goes public through an IPO, the VC firms can exit their investment and diversify by investing in other promising startups or small businesses. Private equity firms can also use an IPO as an exit strategy for their investment in a later stage company.
Venture capital and private equity funds may have established time frames like four to seven years for holding their portfolio company investments.
Venture capital firms or other existing shareholders may decide to sell a block of their existing stock position as part of the registered shares offered in the IPO. Instead of the company, these selling shareholders would receive the proceeds for any shares sold in the IPO.
Like other existing shareholders, venture capitalists may be subject to a lock-up period preventing the sale of its remaining shares up to 180 days after the IPO is effective, as defined in an agreement.
How Does an IPO Impact the Management Team, Board of Directors, and Employees?
The management team and Board of Directors may include the company’s founder and other early investors, plus talented and impressive team members attracted to the company in anticipation of an IPO. Some will leave the company to be replaced in their position, and others will be recruited.
Management team members and some Board members hold significant quantities of restricted shares of stock and vested or unvested stock options before the IPO. The management team, directors, and employees should decide when to exercise their stock options after consulting a tax advisor like a CPA or attorney.
Restricted stock will be reissued as publicly traded shares, subject to lock-up restrictions and pre-arranged trading plans for C-Suite executives and Board members. These Rule 10b5-1 plans for trading shares periodically are designed to protect them from insider trading rule violations.
The company’s management and Board of Directors may be required to report stock holdings and sales and purchase transactions in registration statements and other Securities and Exchange Commission regulatory form filings if they meet SEC threshold disclosure requirements.
Early employees may also hold valuable company shares that should receive higher valuation in the IPO. These employees will be financially rewarded as stockholders through the IPO after their lock-up period expires.
With the IPO process, public companies can offer new discounted stock purchase plans for employees and employee stock option plans (subject to shareholder approval) using SEC Form S-8. These employee stock option plans will be lucrative for retaining and attracting new employees.
Conclusion – The Pros and Cons of Going Public (IPO)
Why companies go public may be related to reaching particular shareholder or asset levels requiring them to file an SEC registration statement to issue public shares when effective. Or going public may be a voluntary, compelling decision based on the pros and cons described in this article or personal factors considered by the CEO and founder.
A company considering going public through an IPO should spend sufficient time thinking about how the advantages and disadvantages of being a public company would affect their decision.
Based on a company’s specific circumstances, sometimes going public is a bad decision.
One advantage of a company going public through an IPO is the ability to raise substantial capital now and in the future on public capital markets when SEC registration filings, including shelf offerings, become effective.
If going public through an initial public offering makes sense for a company, an IPO can also provide advantages for investors, whether they’re early-stage existing stockholders or new investors in the company.
When the advantages outweigh the disadvantages of an IPO, the company can raise abundant capital to achieve its growth strategies (including acquiring other companies using valuable shares). The IPO rewards existing shareholders and attracts and retains talented human capital at the company.