Chapter 6: Reasons why do companies go public?
- Need for capital
- Merits/demerits of taking the IPO route
- Post-IPO strategy
As we already know, IPOs can help companies raise capital for a host of reasons. So, let’s look at the reasons in some detail.
Why companies need capital?
Raising capital helps the company grow, innovate, expand and take risks because IPOs can provide them with financial cushion.
For example, a small start-up will have small investors or families investing in them, without hoping for that much of a return. These kinds of investors are usually called Angel Investors.
But for start-ups to actually compete with large-scale organizations, they always need more capital at the end of the day. This is why many a times, private businesses decide to launch an IPO.
Once the company has ‘gone public’ and if the stocks are doing well, it becomes easy for businesses to grow further. One of the major examples of a successful IPO is the Alibaba Group (BABA) IPO in 2014. That IPO helped Alibaba raise $25 billion.
H2- Advantages of IPO: Raising money
Among the advantages of IPO is the use IPO money for various reasons. Some of them are:
- Cutting down debts
Many companies, planning to go public, run up big debt loads. Therefore, many companies look to reduce their debt levels by using the IPO money. Investors cheer this move because the credit crunch sends debt and financing charges higher.
- Paying off existing shareholders
Although not a very positive move for investors, many companies use the IPO money to pay existing shareholders. In multiple cases, co-owners cash out using the IPO money. This could have a major impact on the share prices of the company as this reveals lack of confidence by the owners themselves.
- Improving liquidity
IPO provides companies a liquidity path. Without a path to liquidity, private company owners may not be able to convert their ownership in the company to any other means of currency or investment.
The overall market sentiments also affect the fate of the IPO, and hence, the liquidity path. If the markets are weak, the company might not receive a fair price for its shares. This, in turn, affects the overall funds raised. In such situations, the company has the choice to wait out the markets, or change course.
The IPO also allows for selling the shares promptly with minimal transactional costs. The private owners of the company can dispose of their stakes in the business both during an IPO and at a later stage. The shares are usually disposed during the IPO by minority financial investors such as venture capitalists.
On the other hand, disposing the shares at a later date, once the IPO has settled, is usually preferred by majority shareholders.
An IPO, is often also considered as a wealth creation event. The founders, workers who have worked hard for the company get an opportunity to monetize their investments.
- Financing future projects
There are companies that fund future projects using the IPO money. Investors and shareholders are especially inclined towards such companies because these steps show potential, accountability towards shareholder’s money and social responsibility. There are many examples where companies are on the verge of a breakthrough and the IPO money serves as the final push towards that achievement.
- Obtaining additional finances
Companies constantly need funds to grow. A company which has raised a good capital from a successful IPO is in a better position to seek further funding from both government and private lenders. This also puts them in a better position to negotiate about the terms of the agreement. Secured loans often require a guarantee, and the funds raised through an IPO can serve as the guarantee.
A successful IPO not only fuels future projects, it also improves the pecuniary situation of the company.
Once the IPO is successful, analysts, financial advisors, traders and investors suss the company in greater detail, recommending the public to buy more and helping the company get new business and bigger projects. This helps improve the company’s balance sheet.
- Mergers and acquisitions
A well-managed company is regularly on the radar of big firms for mergers or acquisitions. Companies also use the IPO money to fund mergers. A successful IPO brings value, credibility and prestige to a company and the added funds serve as the icing on the cake for a successful merger.
An IPO can help M&As in two ways, by providing additional financing or by creating a situation known as “dual tracking”.
- Additional financing
- Dual tracking
- Diversification
- Organic growth
- Purchasing intellectual property
- Visibility and credibility
An initial public offering (IPO) can often provide an essential and a powerful stimulus to private companies who are seeking to acquire other companies as their strategy of growth. In recent years, companies going public are reaching out to the acquisition-driven growth strategy. About one-third of the companies going public make at least one acquisition in their IPO year. To add to this data, typically, a public company makes four acquisitions in its first five years. IPOs also stimulate M&As when their shares are attractively priced. These serve as currency for mergers and acquisitions.
Dual tracking is a phenomenon where a company’s IPO and sell-out occurs in sequence over a short period of time. For many companies, going public increases its valuation, brings credibility and accountability. Ebay’s acquisition of Paypal at a 20% premium after Paypal’s IPO is a classic example of Dual Tracking.
Another use of the IPO money is to invest in other similar businesses, which make the core company even more powerful and successful. Using the IPO money for diversification is a common strategy for many companies.
A possibility for companies is to expand the business organically. Companies do this by hiring more engineers, opening more offices around the world, and ramping up its infrastructure. This expands their network organically and also helps restless investors to see some of the money put towards tangible resources.
Purchasing intellectual property can also be one of the uses for the IPO money. Though not very common, some companies do take pride in owning a healthy portfolio of patents.
A successful IPO can be a terrific branding event for a company. Going public creates a lot of media coverage. The company can leverage this in a number of different ways to help the business.
Plus, the company is expected to disclose its financials to the public. If it is in good shape, it lends further credibility and visibility.
Disadvantages of IPO
The disadvantages of IPO are:
- Costs
The issuance of public equity is arguably one of the most expensive forms of funding. There are various specific requirements as far as financial documents are concerned and these could increase the costs further.
In addition, the preparation of launching an IPO is an expensive affair. There are underwriter’s commissions, registration fees, legal, accounting and other fees to consider too.
- Privacy
A public company is required to reveal sensitive information. It will have to disclose its strategies, finances, contacts and key projects to the public at large. They are also required to reveal their KPIs (key performance indicators) and key calculations about salaries, incentives, profit margins and much more.
- Structure and control
Control of the company, as well as management positions, can be taken away from existing management if a dissident investor or group of investors obtains majority control. This poses a major threat to the existing management.
- Volatility
Once a company goes public, it becomes a part of the stock market universe. At times, there might be volatility in completely other sectors but that might have a knock-on affect on its stock prices as well. External economic factors can also impact the company’s value.
A recap
IPOs can be a great way for private companies to boost its future potential. While there are a few disadvantages, a successful IPO can help improve the company’s pecuniary position, visibility and credibility and its ability to be a part of the mergers and acquisitions ecosystem.
But reaping the benefits of an IPO is just half the battle won.
Why companies keep a close eye on its stock price
Companies can’t let stock prices falter carelessly once the IPO dust settles. That’s because its stock price acts as a barometer of the company’s health. It also reflects an investor’s perception of the company.
A lower stock price is an invitation for a takeover. Other companies are on the lookout for high potential companies with low share prices.
Conversely, a company with a rising stock price is in a better position to take over another company.
Compensation is another reason why companies want the stock prices to remain high. Many executives receive compensation in the form of stock options. Issuance of stock options to executives is an incentive to align the interests of the executives with the overall business strategy and shareholders.
These are some of the reasons why a company remains very careful and concerned about their stock prices even after launching an IPO.
What next?
The following chapter will discuss how IPO pricing is done. We’ll also look at factors that make for a successful IPO and whether they is worth investing in.