As i navigated a corporate and securities regulation course at Sydney University Law school, it became more and more clear to me that despite the fact that i knew the ASX (stock market) listing rules, insider trading principles and a bunch of continuous disclosure regimes found in the corporations act (to be discussed later), I was not anywhere near clear on a number of important questions that kept arising concerning the reality of a company actually raising investment:
- What is the difference between raising investment / capital (used interchangeably) through an IPO (Initial Public Offering) on the stock exchange versus through private equity and do the two ever mix?
- What are the variations of Private equity investment on offer and how do they relate to ‘going public’ through an IPO ?
- What are the different ways private equity firms make their money ?
- When would a company wish to raise capital publicly in an IPO versus privately from a private equity investment group ?
- What factors affect this decision and what are the differing constraints placed on the company in an IPO as opposed to those imposed by a private equity investment group ?
I plan to answer each of these questions over a series of blogs about fundraising, investment and the factors affecting both investors and companies in these scenarios. I cannot outline how complex this area of knowledge can become due to one’s tendency to want to learn everything at once; leaving most frustrated and confused. Hopefully, i will be able to keep everyone’s attention by breaking down what can become complex into simple and useful pieces of information. Please remember i am not writing this for experts.
What is an Initial Public Offering (IPO) ?
An IPO is defined as the first offering of stock or shares to the public by a previously unlisted company. It can happen in a variety of ways but its purpose is to raise capital investment for companies based on their future prospects which are typically expressed in a prospectus made available to the market. Once a company has successfully completed an IPO, it typically becomes listed on a stock exchange like the ASX or the NYSE and is publicly owned up to the proportion that was offered to the public.
Put simply, when a company wishes to gather investment, whether for expansion, the purchase of stock, to cash out an owner’s equity or for whatever reason, a company may decide to begin an IPO and offer stock / equity to the public through the stock market in exchange for capital. To make things complicated, an IPO can and does often proceed via involvement by a private equity intermediary who underwrites the offering but we will get to this in a later blog.
There are various listing rules and disclosure requirements to remain a listed company and the specifics of these will be discussed in a later blog.
What is private equity and what are private equity funds ?
Broadly speaking, the term private equity refers to a class of assets belonging to a variety of possible sources that are invested in companies which are not publicly traded on a stock exchange.
In short, private equity is a source of capital for companies not wishing to raise money publicly; which can happen for a variety of reasons.
Private equity funds typically include venture capital funds, institutional investors, speculators, hedge and mutual funds, and banks / credit unions / trusts / brokers. Typically private equity deals fall into four categories that i found summarised on Wikipedia:
- Venture capital (VC): an investment to create a new company, or expand a smaller company that has undeveloped or developing revenues (eg the technology companies of the late 90’s and early 00’s which typically had ‘high’ prospects and low revenue – high risk);
- Buy-out: acquisition of a significant portion or a majority control in a more mature company usually acquired through a change of ownership (eg a management buy-out or leveraged buy-out – to be discussed later)
- Special situation: investments in a distressed company, or a company where value can be found as a result of a one-time opportunity due to changes in regulations, industry trends, or competition variation
- Merchant banking: negotiated private equity investment by financial institutions in the unregistered securities of either privately or publicly held companies.
Each of these scenarios comes with varying levels of :
- Risk - It is probably clear a company with little revenue that a venture capital firm may target involves more risk than the management buy-out of a profitable company with expected and proven revenue.
- Management constraints and agreements concerning the company being invested in or bought out – these are negotiated on a case by case basis and can vary from the company’s directors / management maintaining full control (as with the Google private equity deal) to them being replaced or infiltrated with the private equity firms’ management teams.
- Cost - Various debt only, debt / equity and equity only combinations are possible as in exchange for the capital investment.
Should a company fundraise through an IPO or private equity ?
Firstly lets get something clear. We are only asking this question because company X needs investment. It has two viable options; public capital or private capital. Each source is not identical for a variety of reasons and before examining these in a later blog, I will introduce them now.
In most jurisdictions, listed or public companies will have more onerous disclosure regimes to their private equity counterparts as the shareholders in privately owned companies are not as heavily protected by legislation for a variety of reasons. The most prominent is that everyday investors are not likely to be as savvy as private investors and as a public policy decision, deserve more protection.
This is an example of a factor that may affect whether or not a previously private company may way wish to seek investment privately as opposed to publicly; that is, it does not wish to disclose certain information to the public. An example of this is the much delayed IPO of Google, where Google did not want to let its competition get ahead by examining the range of information required to be disclosed to the stock market during an IPO.
A paper by Brau, Franis and Kohers (2003) discussed by Cumming identified some the following factors (i added a few) as key in deciding why some entrepreneurial firms go public and some choose to use private equity:
- Industry characteristics
- Market timing
- Demand for funds by private firms
- Deal specific factors such as firm size, contractual governance, insider or management ownership and liquidity
- Market regulations in varying locations
I will go into each of these in the next part of this series which will be found “here” when it is ready but i hope that it is clear how some of these factors may affect a company’s decision to raise capital publicly versus privately. In the mean time, if you are interested in a previous James Cox blog on company valuation, click here.
I am most welcome to any comments or feedback if i have made any errors above.