Tag Archives: stock exchange

The Disadvantages of a Company Going Public or ‘Floating’

Following on from my post about the advantages of company going public, The following article discusses the disadvantages of a company going public through an IPO; as outlined in IPO and Equity Offerings by Ross Gedes.

The disadvantages brought about through the flotation of a company in an IPO are typically perceived differently by different companies with different focuses and requirements.

There are the costs involved that include both the direct costs, in time and money, of the flotation process as well as the opportunity costs of underpricing the offering and subsequently the costs of increased disclosure to public shareholders.

The disadvantages of private company going public are:

  1. Increased disclosure,
  2. Costs of IPOs,
  3. Potential loss of control,
  4. Separation of ownership and control,
  5. Perceptions of short-termism (Wall street),
  6. Meeting investor expectations.

Increased disclosure

When a company moves from private ownership to public, it vastly increases the number of people who have access to its financial records. This can be a huge shock to the existing owners, not just the reporting of the company’s results, but the disclosure of management salaries and perks that often piques the interest of newspaper editors on a slow day.

Companies are required by stock exchanges, securities commissions and regulators to disclose information on a regular basis so that investors and potential investors can make buy, sell or hold decisions. A much greater amount of information is required at the time of the IPO and is included in the offering prospectus.

Disclosure requirements vary by country. Those countries with the largest stock markets, relative to the economy, typically have the highest disclosure requirements (e.g. Australia, Canada, UK, USA).

The development of efficient capital markets in Central and Eastern Europe has been hindered partially by the reticence of corporate executives to disclose information about their firm’s operations and performance.

It’s not all bad though. Botosan (1997) has found that increased disclosure on the part of the company can reduce its cost of equity. By reducing its cost of equity, a company is able to invest in more projects, raise capital more cheaply, and enhance its valuation.

Costs of IPOs

Initial public offerings aren’t cheap. Investment bankers take commissions of between 2 and 7 per cent of the total amount raised; lawyers and accountants bill by the hour, and many hours are required. The ancillary costs, such as public relations, printing, corporate advertising and others can add several hundred thousand more dollars, euros or pounds.

In addition to the upfront costs of the IPO, there are the costs of maintaining a quote on the stock exchange (stock exchange fees, management time, more extensive audits and reporting, reconciliation of accounts to US GAAP if listed on a US exchange, etc.).

However, the direct costs of an IPO can pale beside the indirect cost of underpricing. Because no cash is coming directly out of the issuer’s pocket, underpricing can sometimes be ignored as a cost. It should not be. IPOs around the world are under priced compared with their short-term performance. On average, an IPO will close at a price that is 15 to 20 per cent above its issue price, although this varies by market and industry and over time. This means that selling shareholders and the company are leaving significant sums of money on the table when they go public.

The amount of money left on the table is calculated by subtracting the offer price from the first day closing price and multiplying by the number of shares offered. For example, many analysts believe Google left too much money on the table in its 2004 IPO.


Potential restrictions on management action

In many private companies, the managers are the owners. Therefore there are few restrictions on management action other than statutory and legal regulations and common sense. However, this is not a problem as the linkage of ownership and control should lead to little divergence of opinion about the appropriate course of action for the company.

In public companies, the managers are the agents of the shareholders – they should be acting on behalf of the shareholders and in the shareholders’ best interests. In order to ensure that they do, public companies have boards of directors who are meant to oversee management’s actions on behalf of shareholders. In some circumstances a strong board of directors may limit the actions of management.

Potential loss of control

Not all IPOs are for more than 50 per cent of the issuer’s voting shares, in fact, the average is around 30 per cent. So although control is not lost through the IPO, if the company requires further equity to fuel its growth, existing shareholders will suffer dilution. For the majority of companies, control will pass to public shareholders at some point in time.

‘This risk [passing of control] can be minimized by limiting the number of shares sold to the public, seeking to ensure a broad distribution of shares to the public, creating tiered classes of stock with differential voting rights, entering into voting agreements among pre-IPO shareholders, adopting supermajority provisions or staggering the terms of the directors. Creating a dual class voting structure can depress the price of the shares with less voting power. While some structures may prove more effective than others, there is no guarantee that a public company will not be threatened by a hostile acquiror.’ (Greenstein et al., 2000: 7)

Perceptions of short-termism

One of the most common complaints of corporate management is that Wall Street or the City are too ‘short-termist’. Short ‘termism’ outlines that investors and analysts focus exclusively on the current quarter/reporting period, without giving due consideration to the long-term impact of the company’s decisions. Shareholders generally judge management’s performance in terms of profits and stock price.

Significant pressure exists to increase profits each period and to meet analysts’ expectations and this pressure may cause management to emphasize near-term strategies instead of longer-term goals (Garner, Owen and Conway, 1994).

In order to meet investors’ quarterly or semi-annual earnings expectations, a company may be forced off the long-term strategy that was in place prior to the IPO. Managers may feel compelled to follow strategies that support the share price in the short term, rather than over a long time horizon.

I have watched several interviews with Warren Buffet where he has stated that he predominately wishes for long term investors in his company Berkshire Hathaway to avoid the Wall Street phenomenon of short termism. The corollary of this wish is a somewhat reduced daily liquidity of the stock, but if the company is returning above average dividends over time as a result of better decisions being made, this is less of an issue.

Dealing with institutional investors

Along with the above complaint about short-termism, many chief executives, often those heading a company with badly performing stock prices, complain that the stock market doesn’t understand entrepreneurs, and that entrepreneurial decision making and creativity are stifled by the men in blue pinstripe suits.

Additionally, dealing with shareholders, financial analysts and the press is time consuming. The CEO and CFO/Finance Director should expect to expend, on average, at least one day per month meeting with and discussing the company’s strategy, performance and operations. Those companies that do not establish good relationships with the financial community can find themselves without friends in times of need, such as when faced with a hostile take-over.

‘The performance expectations of Wall Street can only be described as brutal. Miss your earnings forecasts, especially in the first year after your IPO, and you could see a catastrophic decline in the price of your stock of 50 percent or better. Once a young management team has discredited itself with Wall Street, there may be no recovery.’ (American Lawyer Media, ‘The Survival Guide to IPOs’, p. 15)

Whilst many believe the advantages of company going public outweigh the disadvantages, every year dozens of companies voluntarily leave the stock market in what is called a ‘public to private transaction’. These transactions are typically management buy-outs and leveraged buy-outs of the public shareholders and come after extended periods of a depressed share price.

The Advantages of a Company Going Public or ‘Floating’

Whilst reading IPO and Equity Offerings by Ross Gedes, I came across the following advantages of going public. These will be compared with the disadvantages of a company going public in a later post.

The advantages of going public that will be discussed in this article include:

  1. Liquidity and increased share price,
  2. Management and employee motivation,
  3. Enhanced image/prestige,
  4. Access to alternative sources of capital,
  5. Ancillary benefits.

Valuation and liquidity impact

Companies listed on a stock exchange are typically worth more than similar companies that are privately held. The information contained in an IPO prospectus and subsequent annual reports reduces the uncertainty around performance and hence increases the value of a business.

In addition, investors are willing to pay a premium for liquidity: the ability to easily buy or sell shares. Private companies have limited or no liquidity in most cases. The liquidity premium varies over time and economic conditions, but a reasonable estimate would be in the 30 per cent range. This means that if two identical companies exist, one listed and the other not, the listed company will typicallly be valued approximately 30 per cent more than the private company in the marketplace by investors.

Daily liquidity means that insiders know the value of their holdings more accurately, as well as facilitating further sales of shares. This leads a good proportion of private companies to at least consider going public.

Motivate management and employees

The use of incentives such as stock options and stock bonuses to attract and retain both employees and management became very popular; particularly in the USA and UK during the 1990s.

Equity-based awards and ownership tend to be spread more broadly among management and employees in public companies compared to private companies. In addition, management and employees of public companies can see the results of their efforts in the share price more immediately.


Prestige/enhanced image

A significant, but intangible, benefit of a flotation is the increased visibility of the company through its ongoing disclosures to the stock exchange or securities commission. Many analysts believe there is considerable prestige attached to managing and working for a publicly listed company.

A flotation may bring marketing benefits, by making the company seem stronger and more substantial. Press coverage of public companies is typically greater than that of privately owned firms.

These factors can lead to the recruitment and retention of higher quality employees and increased sales due to greater corporate exposure.

‘While both good and bad news must be disseminated to enable investors to make well-informed decisions, a public company that is well run and compiles a record of success can gain a first class reputation that can prove an immeasurable benefit in many ways. As a company’s name and products or services become better known, not only do investors take notice, but so do customers and suppliers, who often prefer to do business with well-known companies.’ (Garner et al., 1994: 17)

Access to alternative sources of capital

Another benefit as a result of a company going public is the ability to gain access to alternative sources of capital in the future. Public companies are often able to raise money for expansion more easily and at better rates than private companies of similar size. The public debt markets are more accessible to public companies than to companies without a listing.

Moreover, going public generally improves a company’s debt to equity ratio and may enable it to borrow on better terms in the future.

One study by Pagano et al. (1998) found that Italian companies that went public were able to borrow more cheaply after their IPO. They also found that the number of banks willing to lend to a company increases after its flotation. However, they report that a similar study conducted in Spain (Planell) uncovered no significant decrease in interest rates paid after the IPO.

Ancillary benefits of flotation

The flotation process often forces a company’s management to formulate and document a clear business strategy for the first time.

This is typically beneficial to the future success of the business and in many cases is just what a private company required to truly grow from small to medium or from medium to large in size.

Along similar lines, the anticipation of public ownership leads many companies into improving their management and financial structure. Fast growing medium-sized companies often neglect the formal structures which will help them in their attempts to become larger and more profitable companies.

If you enjoyed this article, please also have a look at my blog on the disadvantages of a company going public.

What is involved in a career in investment banking ?

investment banking

After reading The Accidental Investment Banker by Jonathan Cree, I decided my first blog on investment banking and corporate finance was due.

From my understanding of investment banking, many people simply don’t understand it. Is it banking? Is it investing? Is it Gordon Gecko in the movie Wall Street or is he a trader? What is the difference between an investment banker and an equity trader? What do investments bankers actually do?

One finance degree short of an answer, it took me a fair while to truly come to grips with the concept of investment banking. However, now that I have, I feel the short summary below will give a very good indication to those considering a career in investment banking or those wishing to understand investment banking better.

What is investment banking and what do investment bankers do?

As companies grow, they need capital. In many cases, in order to raise capital and for other related advisory services, companies go to investment banks. Investment banks provide a range of services relating to the raising of capital and act as advisors to the world’s corporate leaders… Continue reading What is involved in a career in investment banking ?

Fundraising and Investment through IPOs and private equity (part one)

Fundraising

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. Continue reading Fundraising and Investment through IPOs and private equity (part one)

9 key definitions to understand the valuation and earnings of companies

learning goggles - key valuation definitions

Valuation of Companies and 9 key definitions

After skimming through The Fast Forward MBA in Finance, Second Edition by John Tracy, a few key concepts (such as EPS, ROE, market capitalisation and P/E) kept coming up again and again when dealing with the value of companies. When read in combination with Joel Greenblatt’s book, The Little Book That Beats the Market which simplifies things to some degree, an understanding of these concepts is required to begin understanding whether a company is undervalued or overvalued on the stock exchange and hence whether you should invest in the company.

It is important to firstly recognise that the value of a company’s shares on the stock exchange is only a representation of what the public will pay at any particular time for a stake in the company and is not a direct representation of the company’s true value per se. This fact is actually why smart investors should always be able to make money investing the stock market. For example, if an investor is able to identify a under or overvalued company, they can make the appropriate decision to either buy the stock if it is undervalued or sell the stock (we’ll come to how you can sell stock you don’t have later) if it is overvalued. Over time, whether it is overnight or over 5 years, the market will correct itself and the investor will profit from his analysis of the companies true value compared with the market’s perception of its value.

In later posts, I will describe how Greenblatt’s book proposes a magic formula strategy for identifying undervalued companies based on a company having a high earnings yield and a high return on capital. Firstly, however, this post will aim to explain these concepts so that we can get familiar with them first. Some of the definitions below are drawn from Tracy’s glossary in The Fast Forward MBA in Finance, Second Edition.

Continue reading 9 key definitions to understand the valuation and earnings of companies