Public vs. Private: Advantages, Disadvantages and Trends in Raising Capital
10/19/2017

A corporation must be relatively certain there is a public thirst for its shares before “going public.” If there isn’t, a public offering is a very expensive waste of time and effort. Determining the right course to take is a major decision, and experienced counsel can help explore options and assist with private capital alternatives. 

Assuming there is public interest in the shares, when a company “goes public,” it sells newly issued shares of its stock, or debt, in an initial public offering (“IPO”), often through the New York Stock Exchange or over-the-counter on NASDAQ, after registering the offering with the Securities and Exchange Commission (SEC). 

A corporation becomes a “public company” either after going through an IPO, or by registering as a “reporting company” for secondary trading under the Securities Exchange Act of 1934. A “private company” typically has a smaller number of equity owners and so is not required to register for secondary trading and file periodic public reports with the SEC until it reaches certain thresholds.

Public Vs. Private: Advantages and DisadvantagesAdvantages of an IPO

Going through an IPO and being a public company may provide significant advantages for the company and its shareholders. There is the obvious infusion of cash, it may mean easier and quicker access to equity and debt markets in the future, and liquidity for pre-IPO shareholders and the increase in stature of the company in the eyes of the public. 

The common theme of these advantages is that a liquid market for its shares “unlocks” value that the company could not otherwise access. By having publicly traded stock, the discount attached to stock of private companies no longer applies.

• Cash Infusion: The result of an IPO is a significant and immediate infusion of cash into the company. This cash is typically “earmarked” for specific uses described in the IPO disclosure documents. These uses of the proceeds can be for a variety of purposes. For example, the company may use the money to expand its inventory, property and equipment base, to reduce debt, further research and development or expand its services.

• “Minting of Coin” Having an established value and liquid market for its stock creates additional “coin” for the company through issuance of additional shares. This “coin” may be used as consideration to acquire other businesses and to compensate both current and future employees.

The ability to utilize the company’s stock for an acquisition significantly decreases its need for cash and allows it to engage in transactions without tapping into its “war chest” of IPO proceeds, which can be put to use to fund future growth. In addition, acquisitions using the company’s stock as consideration may be structured as a “tax-free” reorganization, which can allow the sellers to defer taxes on gains associated with the sale of their business. Using stock as consideration for acquisitions also provides sellers an opportunity to participate in the future growth of the combined organization.

Another benefit of a liquid market for a public company’s shares is that its stock may be used to compensate both its existing and future officers and employees through the grant of options or direct issuance of shares. Grants of options or stock provide a means to share the company’s success and are a great tool for attracting talented management and employees.

• Access to Capital Markets: Being a public company enhances access to both equity and debt markets. After the company has been a reporting company for 12 months, it may engage in follow-on offerings using a “short form” registration process. The ability to use this process reduces both the time and expense of future equity financings.

As a reporting company, the transparency of its financial position and operations makes it better suited to obtain debt financings. The infusion of cash from an IPO also enhances the balance sheet and makes the company a much stronger candidate for debt financings.

• Liquidity: An IPO provides liquidity to the company’s founders, employees and pre-IPO investors holding the company’s stock, i.e., they can sell their shares. While the liquidity may not be realized right away due to “lockup” requirements imposed by underwriters and other SEC rules, being a public company provides a means for the pre-IPO stockholders to monetize the value of their stock at some point in the future.

• Institutionalization: Being a publicly traded company adds to the company’s stature as an institution, which can enhance its competitive position. The IPO process itself generates publicity that may enhance the company’s recognition in the marketplace. As a result, suppliers, vendors and lenders often perceive the company as a better credit risk and customers may perceive it as a better source of products or services. The stature of a public company can also enhance its ability to attract top level executives and employees.

Disadvantages of an IPO

Disadvantages of “Going Public”

While going public provides significant advantages to a company and its stockholders, the requirements imposed under securities laws can mean significant disadvantages to the company and its operations. These include increased costs, securities law compliance, changes in corporate governance structure and becoming a “slave to the stock price.”

• Costs: The costs of an IPO include both the costs of engaging in the IPO process and the future and ongoing costs of being a public reporting company. Costs go up as the amount raised increases. These costs include underwriting commissions, legal and accounting fees, SEC and Financial Industry Regulatory Authority (“FINRA”) filing fees, exchange fees, financial printing, travel and other miscellaneous costs related to an IPO. 

In addition to these initial costs, as a public reporting company, companies face a new array of securities laws and regulations, including the Sarbanes-Oxley Act and exchange listing requirements. Public companies have significant ongoing costs associated with their public status, including outside directors’ fees and expenses, directors’ and officers’ liability insurance, accounting and legal costs, internal control costs, printing costs for stockholder reports and proxies and costs of investor relations.

The costs are not just financial. The IPO process can take up to six months or longer. During this period, the company’s executive management team must devote substantial time and energy to the IPO. This takes away from management’s time and ability to run the company’s business, and operations may suffer during the IPO process.

• Securities Law Compliance: A myriad of compliance issues results from the IPO process. Severe restrictions are imposed on the company’s marketing and publicity activities during the “quiet period” preceding the filing of a registration statement. The registration and reporting process involves the disclosure of significant information about the company that is readily available to the company’s competitors and other public scrutiny. 

Following completion of the IPO, the company will be required to file quarterly, annual and current reports detailing its operations and announcing major events, both good news and bad news. This disclosure includes detailed information about operations, executive compensation, financial results and significant customers and vendors. Proxy statements must be filed with the SEC before a stockholders’ meeting can be called. 

The company cannot release information on a selective basis and must be careful to assure that the information it releases is accurate and complete. Company insiders and major stockholders also must comply with the Exchange Act requirements for reporting their stock ownership and prohibitions on short swing trading. Finally, the exchanges where the company’s stock is traded have various listing standards under which additional governance and disclosure requirements are imposed.

The changes to the securities laws resulting from the Sarbanes-Oxley Act have greatly increased the compliance issues that a public company must address (with corresponding cost increases). These include enhanced auditing and governance standards, additional responsibilities for the company’s independent directors, development and documentation of control procedures and certifications by the CEO and CFO. The certification requirements are backed up by possible criminal sanctions for violations.

• Change in Corporate Governance Structure. Major stock exchanges require that in order to be listed, the company’s board must be comprised of a majority of independent directors. Independent directors cannot be officers, employees, major stockholders or outside service providers. Independent directors must comprise the audit, compensation and corporate governance committees. 

This means that the selection and oversight of auditors, setting executive compensation and determining board candidates and litigation issues are in the hands of the independent directors, taken away from management and given to “strangers” who may have little past experience with the company’s operations. Exchanges also require listed companies to hold annual stockholders’ meetings. Matters such as calling meetings and presenting proposals to stockholders must now be accomplished in compliance with SEC rules.

A major change brought about by Sarbanes-Oxley was empowerment of the independent directors. Previous “best practices” of having a majority of independent directors are now mandated by exchange listing requirements. The independent directors are charged with oversight of the company’s management and auditors. For most companies, particularly where the founders are executive management, the change in corporate governance structure resulting from being a public company may take some adjustment.

• Becoming a “Slave” to the Stock Price. It is often said that a professional baseball pitcher is only as good as his last outing and that a CEO of a public company is only as good as her company’s last quarter. While a fluid and liquid market in a company’s stock unlocks value, a public company’s stock price is frequently subject to rapid fluctuation. The stock price can be affected by a variety of factors, over which management may have little or no control. 

Reporting of quarterly earnings can lead to decision-making based on the short term result when a longer term perspective would be better for the company. The close ties between executive compensation and their personal net worth to near term operating results enhances the dilemma of seeking short-term results at the sacrifice of long-term perspective. Wall Street can be impatient and, as with baseball pitchers, may have a tendency to look only to immediate past results rather than the big picture.

A loss of stock value can lead to dire consequences, such as stockholder lawsuits, loss of confidence in management and possible hostile takeovers. Lawsuits can stem from a sudden decline in stock price. Defense of a stockholder class action lawsuit can be very costly and distract management from running the business. 

Recently, stockholder activism has been on the rise and dissatisfaction with directors (including executive management on the board) has been evidenced by stockholders withholding approval of directors. Various proposals, such as mandatory removal of directors who do not win a majority of stockholder approval in elections, are increasing the pressures on management to perform on a quarterly basis. 

If a company loses favor with analysts and stockholders, its stock may suffer additional devaluation, which could lead to it becoming attractive to a hostile takeover bid. A successful takeover, particularly a hostile takeover, could result in the company’s founders being removed from management positions.

Recent developments

Given the enhanced oversight and compliance responsibilities imposed on corporate officers under Sarbanes-Oxley in the wake of the dot-com boom and bust in the early 2000s, a lot of the advantages of being a public company were offset. It became a lot more expensive to comply, and there were a lot more regulatory “land mines” to maneuver around. 

Further, class action suits continued to plague public companies when share prices fell or published accounting information had to be restated given the discovery of prior problems. In many cases, being public simply was not worth the trouble.

Then the JOBS Act came along in 2010, and brought with it several new rules and regulations that further diminish the need to conduct a formal IPO, and without sacrificing many of the benefits. First, the SEC was directed to promulgate rules that made private capital formation easier and broadened the options available. 

For smaller issuers, the maximum amount an issuer could raise under Regulation D, Rule 504 is now set at $5 million (raised from $1 million), keeping the requirement for registration at the state level to raise that amount publicly. 

A new wrinkle was added to venerable (and state preempted) Rule 506. While old Rule 506, renumbered Rule 506(b), remains in place, with its unlimited amount that can be raised but its prohibition on public solicitation, a new Rule 506(c) was adopted, allowing an issuer to publicly solicit for investors, provided sales are limited to accredited investors whose status is verified by the issuer. 

While shares sold under Rule 506(b) or (c) remain restricted and are not freely tradable afterwards, an issuer can raise an unlimited amount of money from an unlimited number of accredited investors. Who needs the expense and headache of an IPO?

Further, the amount that can be raised under old and rarely used Regulation A (formerly $5 million with SEC review and state registration required) has been increased to up to $50 million. Two tiers were established, with a $20 million cap but lesser requirements, but with both SEC review and state registration, or Tier 2, raising up to $50 million with tougher initial and follow-on requirements, but only SEC review. Once cleared for use, both Tier 1 and Tier 2 issuers can publicly solicit for investors and the shares sold have the advantage of being freely tradable (not that a market for the shares is guaranteed).

Finally, the SEC was directed to adopt rules allowing federal equity crowdfunding. With a cap of $1 million in a 12-month period, this method is for only the smallest of capital raises.

In addition to these new means of raising capital, a new category of public companies was defined, “emerging growth companies” (“EGCs”). The thresholds for when a private company must register for secondary trading under the Securities Exchange Act are increased significantly, meaning a company can remain private much longer before it is required to make their affairs public. 

Given the new latitude to look for investors publicly without having to register an offering with the SEC, and the increased thresholds for remaining private, many companies have decided the expense and follow-on responsibilities of an IPO simply is not worth the benefits. 

The number of IPOs has fallen so dramatically that the SEC actually commissioned a study to find out why. Efforts are underway to try to reinvigorate the IPO market, but the factors militating against “going public” remain stiff obstacles to all but the largest companies.

Conclusion

While going public can have many positive effects on a company and its operations, these positive effects must be balanced against the disadvantages, particularly in light of the alternatives. Going public drastically changes a company’s culture and has an ongoing impact on business operations. 

Determining if going public is the right course for a company to pursue is a major decision and must be carefully considered by management before this course is undertaken. We can help you determine which option may be best for your company, and assist with private capital alternatives if that approach best suits your needs.

We can help you determine which option may be best for your company, and assist with private capital alternatives if that approach best suits your needs. Please contact Scott D. DeWaldPhilip A. FeiginKevin M. Kelly or Matthew C. Sweger for more information.

Photo by Simon Cunningham