Advantages and disadvantages of going public

Capital for growth

Growth opportunities often require substantial capital, and an IPO is an excellent means of obtaining this capital. An IPO allows a company to raise these additional funds either on an equity basis or on an equity basis combined with additional debt financing obtained from a financial institution or other intermediary. An IPO provides the company with cash to support growth and the related working-capital needs. Access to the public market will continue to be available if your stock performs well.

Less dilution

The price received for the securities is usually higher in an IPO than through a private placement or other form of financing.

Liquidity and personal wealth

A major portion of shareholders’ net worth might be tied up in your company’s stock. Once your company has completed a public offering, an active trading market usually will be established for the company’s common stock. A market for these shares might mean that, over time, these shareholders can convert some of their common shares to cash and diversify their personal investment portfolios. This liquidity also allows for increased estate-planning opportunities by making the value of the estate more readily ascertainable and allowing the sale of shares in the market for cash. Another factor to consider is that your shareholders’ personal net worth might significantly increase as a result of an IPO. However, it might be unlikely that significant shareholders and key officers will be able to sell stock in the IPO because of the appearance of insider trading.

Employee recruiting and retention

Stock-based compensation programs, usually stock-option programs, are one way to attract and retain key executives and managers. These programs are especially attractive if the company’s common stock is publicly traded. A stock-based compensation program might provide certain tax advantages to key executives and additional capital for the company. Also, if management successfully increases the company’s earnings and long-term value, a successful stock compensation program might enhance the market price for the company’s shares and create greater wealth for key employees and shareholders.

Acquisition strategies

An IPO is an excellent means of positioning your company for future acquisitions. A public company often can use its common shares, either alone or in conjunction with cash or debt, to acquire other companies, which would otherwise require the outlay of significant cash.

Improved ability to borrow

The sale of common stock increases your company’s net shareholders’ equity and improves its debt-to-equity ratio, which can improve your company’s ability to borrow on more favorable terms in the future.

Possible competitive advantages of going public

The publicity the company receives in going public provides name recognition and increased visibility. Although such publicity is usually positive, it should be noted that negative publicity also is a possibility as a result of an IPO.

Stockholder interest

Customers, suppliers and employees who own stock will have a heightened interest in the company’s success.

Control

An IPO generally results in more passive shareholders than other forms of financing.

The personal “tug-of-war”

In certain closely held businesses, owners are not overly concerned with conflicts resulting from personal-versus-business implications of various transactions. However, in a public environment, it is critical to separate personal and business transactions. In fact, most transactions involving personal conflicts must be eliminated from the business either prior to the IPO or upon its completion.

Privacy

Regulatory rules require a company to disclose a wide array of information, including profitability, financial strength, competitive position, line-of-business and product-line information, related-party transactions, executive compensation, and fringe benefits. In most cases, this information previously has not been disclosed to anyone, including most employees. In particular, detailed disclosures comparing your company’s executive compensation and performance with other industry members are required. These disclosures often are viewed by privately held companies as a major disadvantage of going public. Some business owners find it unthinkable that their employees, customers, suppliers and competitors, among others, will know their compensation, the nature and amount of related-party transactions, and other previously confidential information.

Loss of control

Depending on the size of the IPO and subsequent offerings, a major shareholder might lose absolute voting control of the company. While a major shareholder might still have the largest single block of common stock and thereby still have effective control, that shareholder might be uncomfortable with not owning more than 50% or legal control of the outstanding voting common shares. This concern can be minimized by having a wide distribution of stock to many new shareholders through a retail rather than or in addition to an institutional investment banker, so a concentration of holdings does not occur. Further, poor performance can result in substantial internal and market pressure and, in some cases, loss of management control, since you will have a number of outside (nonemployee) directors as a public company.

Compensation

Public companies usually have a compensation committee that makes recommendations on matters regarding executive compensation. The level of compensation and benefits the company paid as a private company might not be appropriate for a public company.

Reduced management flexibility

As a public company, certain decisions that previously were made unilaterally by management or the owner group will now require approval by the board of directors or shareholders. This can result in reduced management flexibility and require more management discipline.

Costs

There are usually significant transaction costs associated with completing an IPO. The initial cost of an IPO can be as high as 10% to 15% or more of the gross proceeds of the offering, depending on its size and complexity. In addition, substantial costs and time can be expended on an offering that is abandoned at the last minute due to unfavorable market or other conditions beyond your control. This can result in significant costs that might have little or no future benefit to your organization.

Upon completion of an IPO, public companies become subject to new regulations and reporting requirements. Your expense for accountants, legal counsel and consultants will increase significantly as they help you comply with applicable laws and regulations. In addition, the application of these new laws and regulations might result in some cultural adjustments and strain for your management resources.

Performance pressure

The stock market is concerned with current quarterly performance, and a company that misses estimated earnings by only a few cents per share can experience a significant adverse effect on its share price. This threat frequently creates substantial pressure on management to meet performance expectations, a short-term emphasis that can be detrimental to long-term performance. A management team not previously concerned about a company’s price per share, or that previously operated with an emphasis on tax minimization, can find this pressure difficult to handle. Development-stage companies usually will be given some grace, but eventually the market will demand performance.

Stock price volatility

After a company goes public, the price of its shares is affected by many factors other than its historical financial performance, including the overall state of the economy, stock market fluctuations in general and adverse events in the company’s industry, so in spite of good financial performance, your company’s stock price may not perform as you believe it should. This can be frustrating, as the value of the stock is affected by these market swings.

Opportunity cost

The process of completing an IPO can have a short-term negative effect on the business. You must allocate a substantial amount of executive and management time to the IPO process and should anticipate distractions from your company’s day-to-day business activities. The executive and managerial time required for an IPO is usually far greater than initially anticipated.

Responsibility to shareholders

Management will have a permanent responsibility to public shareholders, and must take into account the effect on the shareholders when making decisions.

Sharing growth

If the company expects to experience a rapid increase in profits in the years immediately following the IPO, and other resources (e.g., bank loans) are available to finance that growth, the company may be better off delaying the IPO so as to not share that growth in value of the business with new shareholders.

Restricted shares

Only the shares sold to the public in an IPO are free to trade in the market. Owners’ shares are not freely tradable unless sold or registered through a registration statement or pursuant to SEC Rule 144. Owners’ shares and those of certain officers are restricted from being sold into the public market for a period of time. Additionally, officers cannot sell their shares if inside information is available to them that is not available to the public.

Housekeeping

Many times, the company will have to modify its corporate bylaws and/or charter to complete an IPO. In addition, all corporate records will have to be brought up to date to pass due diligence by the underwriter.

The decision is final

Once you have become a publicly owned company, it is extremely difficult or impossible to reverse the process. Therefore, make sure this is the road you wish to travel before completing this course of action.

Does company size make a difference?

One of the most commonly asked questions when considering a public offering is how large a company must be to go public. There is no single correct answer because IPOs are undertaken by companies of all sizes—from start-up companies in the research-and-development stage to established companies looking to expand their operations.

For established companies, it is most important that there is a sound management team in place and a high likelihood of significant growth in sales and profits in the near term. Predictability of sales and earnings growth is also a major advantage. To evaluate whether the public will be interested in your company’s securities, you should evaluate your company’s sales and earnings performance over the past five years and your prospects for the future. If this evaluation shows above-average growth in sales and profits, the public likely will be interested in your company’s securities.

On the other hand, some start-up companies successfully complete IPOs even though they have losses or limited revenue. In these cases, the company usually has some other characteristic that overcomes this lack of profitability and/or sales. These characteristics might include a unique new product or concept, operations in a business sector favored by the markets, an outstanding management team with a track record of significant successes, or a recent development that has positioned the company for outstanding growth in the future. Examples might include a high-tech company, a software company or a company in the alternative-energy industry.

How much capital can the company raise?

How much money a company can raise in an IPO is dependent upon several factors, such as the company’s value, the current condition of the stock market, the percentage of the company that the existing shareholders are willing to give up (dilution), the business stage of the company, the uses to be made of the funds received, and the underwriter selected. It is sometimes advantageous to raise a lesser amount in the initial IPO, and additional funds in a subsequent offering. This approach can minimize the initial dilution of your interest compared to a larger IPO and delay raising capital until it is needed. However, it is essential that a sufficient number of shares of common stock be sold to enable an active trading market to develop. In addition, going public is an expensive process, and there are no assurances that subsequent offerings will be completed.

Can I sell some of my stock in the IPO?

Whether an owner can sell personally held shares of common stock in an IPO and the amount that can be sold, if any, are questions for you and the underwriter to determine. Usually, however, the inclusion in an IPO of shares owned by individuals who are active in the operation of the business is discouraged if it might be construed as a “bailout” of the current owners/managers. The sale of some or all the shares owned by minority shareholders not active in the business is usually acceptable up to specified limits. This does not mean that you cannot sell any of your common stock if you are active in the management of the business. However, the sale of such shares allowed by the underwriter is usually limited.

Further, the underwriter usually will require a lock-up agreement with major shareholders/managers for a period after the offering—typically six months, but occasionally up to a year. This agreement provides that, even if permitted under the securities laws, these individuals cannot sell shares in the open market until after the expiration of the lock-up period. The intent of the lock-up agreement is to avoid any inference that management or major shareholders are bailing out of the company, which could adversely affect investors’ perceptions about the company’s future and, as a result, jeopardize the underwriter’s ability to sell shares to the public. Frequently, management shareholders precluded from selling shares in the IPO will be able to sell some shares in a future public offering and, in any event, will be able to sell a limited number of shares in the open market after holding the shares for at least two years.

How much of the company will I need to give up?

One of the greatest concerns of an owner or manager of a closely held business is, “What amount of ownership percentage do I have to give up to raise the funds I need?” The answer is normally dependent upon the company’s size, the size of the offering, the near-term outlook for the company and the need for and use that will be made of the funds raised. This topic should be discussed initially with your underwriter to ensure you are in agreement with the anticipated ownership dilution prior to moving ahead with the offering.

How can my employees participate in company ownership?

This issue is most frequently handled by having the company adopt an incentive stock-option plan, either in anticipation of or concurrent with the IPO. Many owners of private corporations have precluded employee ownership in their companies and elect to adopt a stock-option plan concurrent with the IPO. This allows employees to acquire shares at fair market value on the date the options are granted, usually representing the offering price, but to defer the investment decision throughout the term of the option. In addition, options are an excellent vehicle to retain employees by making the options subject to vesting requirements. Of course, in most instances, employees might also purchase shares directly in the open market after the IPO.

Can customers, suppliers and friends purchase shares of my company’s stock?

This question is important if there is significant demand for the company’s common shares and it appears that the offering will be oversubscribed. Generally, you cannot sell shares directly to customers, suppliers or friends of the company. However, underwriters will sometimes assist these groups by allocating some shares to specifically named organizations or individuals. This is a matter to be discussed with the underwriter well in advance of the sales effort.

How can I use the funds raised in an IPO?

Funds raised in an IPO can be used for any valid business purpose, including business or asset acquisitions, repayment of existing indebtedness, research and development activities or working capital and other needs. The greatest success, however, is attained when the proceeds from the sale of shares is used in connection with a well-thought-out business plan, which provides for long-term value growth through expansion of the business, as opposed to debt repayment. Careful consideration should be given to how the proceeds will be used because the planned use of the proceeds must be disclosed in the registration statement, and the proceeds must be expended generally as disclosed. Subsequent to the IPO, the company will be required to report its actual use of the proceeds in its periodic reports filed with the SEC.

How is the stock price determined?

The proposed selling price of the securities to the public, and accordingly, the amount of net proceeds to be received by your company and the selling shareholders, if any, are determined by the underwriter at the conclusion of a preliminary investigation of the company. The underwriter generally considers the company’s future earnings potential, the current stock market conditions and the condition of the industry in which your company operates. The IPO price normally will be set as a range and at a discount from the anticipated after-market selling price. Naturally, you would like to receive the highest price possible for your company’s stock. However, an excessively high IPO price may not be to your company’s advantage. If the initial offering price is perceived as too high by potential investors, the underwriter might have difficulty selling shares in the IPO. Additionally, a weak after-market could result if the price of the company’s shares falls below the offering price. This obviously has an adverse impact on the company, IPO investors and the underwriter’s reputation.

Although the underwriter determines the offering price, you should make a preliminary evaluation of your company to assess the fairness of the proposed price. In the final analysis, you must determine if you are willing to sell shares at the proposed IPO price. You certainly do not want to incur the cost of proceeding with an offering only to determine later that the price is unacceptable. A qualified valuation specialist often can assist you in evaluating the reasonableness of the proposed offering price or in determining a reasonable fair market value for your company.

Once the offering price has been determined, the underwriter likely will propose changes to your authorized shares and will inform you of the number of shares it anticipates purchasing for resale to the underwriting syndicate or the public. Also, the underwriter usually will negotiate an over­allotment option of up to 15% of the shares offered. If market acceptance is good, the underwriter often will purchase these additional shares from your company at the original offering price for immediate resale to meet this high demand.

A word of caution—the underwriter is not committed to a final price until immediately before the registration statement becomes effective, even if the managing underwriter has indicated a price range that you have found acceptable. At that time, you will have incurred substantial out-of-pocket costs and have expended significant time in the IPO process. However, the actual price might be substantially less than the initial price range due to market changes or other factors that were not anticipated at the time of the initial pricing decision. If you determine the price to be unacceptably low, you are not obligated to proceed with the offering.

What are the tax consequences of going public?

For most private companies, there are no significant tax advantages or disadvantages in being a publicly held company, except that the company can no longer operate as an S corporation or as a limited liability company. However, if your company has experienced significant losses in prior years and is in a net-operating-loss carry-forward position, a public stock offering might severely limit your use of these net-operating-loss carry forwards in the future. Therefore, before undertaking an IPO, management should carefully evaluate the impact the offering may have on the company’s current and future income tax situation. In addition, a careful review of any tax accounting exposure areas should be performed. Appropriate actions should be taken before the IPO process begins.

It is critical that the major shareholders of a private company involved in an IPO develop a comprehensive personal tax strategy before the IPO is commenced. In many instances, the market value of the shares of a private company that goes public will increase substantially. Matters that should be considered in this strategy include:

• The gifting of shares to children and/or other family members prior to the public offering to minimize gift, estate or income taxes
• The timing of the offering and the amount of gain to be realized from the sale of shares if a secondary offering is contemplated by the major shareholders
• The change in cash compensation and employee benefits (e.g., insurance, stock options) to be received from the company as a result of the offering

Where will the stock be traded after the offering?

A company can file for listing on Nasdaq, the New York Stock Exchange or other exchanges if listing requirements can be met. These requirements change periodically, and you should review the requirements with your attorneys if you want your shares to be listed on one of these exchanges.

Should a SPAC be considered?

A special-purpose acquisition company (SPAC), also known as a blank-check company, is a company that is funded through an IPO and formed for the sole purpose of acquiring one or more target companies. Sometimes SPACs have a specific target company in mind before the IPO, and sometimes the target is identified after the IPO. Funds raised in a SPAC IPO are held in a trust account until the acquisition is completed. SPACs are regulated by the SEC, and the acquired entity becomes subject to all relevant SEC filing requirements.

Negotiating a merger with or sale to a SPAC is an option for a privately held company, and can be a “fast track” into the IPO process because the SPAC sponsor often is experienced in the complexities of SEC regulations and because a SPAC generally must either complete an acquisition within a specified time period, for example two years, or it must return its funds to its investors. However, due to SEC filing and financial statement presentation requirements, a SPAC transaction is more complicated than selling to one individual investor. Professional advisors can help companies analyze the tradeoffs in a transaction with a SPAC compared to a traditional IPO or a sale to a private or public entity.