The Ups And Downs Of Initial Public Offerings

By Marc Davis AAA

Enticed by huge run-ups in the stock prices of companies that have recently gone public, owners and partners in privately held firms consider an initial public offering (IPO) as the road to riches. Many companies pursue IPOs as a means to increase the amount of available financing to the company and possibly generate billions for the owners in the process.

TUTORIAL: IPO Basics

But there's many a bump, detour and dead end on that hoped-for path to bundles of stock market cash. And too many companies that think they're prepared for the big time with a New York Stock Exchange or Nasdaq IPO may be far from ready.

Going public – an initial public offering of stock – can be an effective means of raising cash for corporate ventures. But before undertaking the complex, expensive and time-consuming preparations, and incurring the risks involved, the upside and downside of this critical move must be fully assessed. Although there are numerous benefits to being a public company, this prestige comes with an increased amount of restrictions and requirements. (IPO ETFs are a relatively new way to better invest your money - but there is some risk involved. Check out IPO ETFs Inside And Out.)

The Upside of Going Public
Money to grow the business: With an infusion of cash derived from the sale of stock, the company may grow its business without having to borrow from traditional sources, and will thus avoid paying the interest required to service debt. This "free" cash spent on growth initiatives can eventuate in a better bottom line. New capital may be spent on marketing and advertising, hiring more experienced personnel who require lucrative compensation packages, research and development of new products and or services, renovation of physical plant or new construction and dozens of other programs to expand the business and improve profitability.

Money for shareholders and others: With more cash in the company coffers, additional compensation may be offered to investors, stakeholders, founders and owners, partners, senior management and employees enrolled in stock ownership plans.

Company stock and stock options may be used in an effective incentive program. In recruiting talented senior management personnel, stock and options are an attractive inducement. For employees, a performance-based program of stock and or option bonuses is an effective means of increasing productivity and managerial successes. Stocks and/or options may also be used in other forms of compensation, as well.

Other benefits of going public: Once the company has gone public, additional equities may be easily sold to raise capital. A publicly traded company with stock that has performed successfully will usually find it easier to borrow money, and at a more favorable rate, when additional capital is needed.

A publicly traded company may also have more leverage in negotiating with vendors, and be more attractive to customers. This is a critical aspect of business, and a company that keeps vendor costs low may post better profit margins. Customers usually have a better perception of companies with a presence on a major stock exchange, another advantage over privately-held companies. This is largely due to the regular audit and financial statement scrutiny that public companies have to undergo on a regular basis.

A publicly traded company conveys a positive image (if business goes well) and attracts high-quality personnel at all levels, including senior management. Such companies are growth-oriented, they answer to a board of directors and shareholders who continually demand increased profitability, and are quick to rectify management problems and replace poorly performing senior executives. (Thinking of investing here? We give you five tips to remember. See The Murky Waters Of The IPO Market.)

The Downside of Going Public
Once a company goes public, its finances and almost everything about it – including its business operations – is open to government and public scrutiny. Periodic audits are conducted; quarterly reports and annual reports are required. Company finances and other business data are available to the public, and can sometimes work against company interests. A careful reading of these reports can accurately determine a company's cash flow and credit-worthiness, which may not be perceived as positive.

The company is subject to SEC oversight and regulations, including strict disclosure requirements. Among the required disclosures is information about senior management personnel – particularly compensation – which is often criticized by the stakeholders.

The company is subject to shareholder suits, whether warranted or not. Lawsuits may be based on allegations of self-trading or insider trading. They may challenge executive compensation, or they may oppose or question major management decisions. Sometimes a single, disgruntled shareholder may bring suit and cause expensive and time-consuming trouble for a publicly traded firm.

Preparation for the IPO is expensive, complex and time consuming. Lawyers, investment bankers and accountants are required, and often outside consultants must be hired. As much as a year or more may be required to prepare for an IPO. During this period, business and market conditions can change radically, and it may not be a propitious time for an IPO, thus rendering the preparation work and expense ineffective.

The pressure for profitability each quarter is a difficult challenge for the senior management team. Failure to meet target numbers or forecasts often eventuates in a decline in the stock price. Falling stock prices, moreover, stimulate additional dumping, further eroding the value of the equities.

Before buyers and original holders of the IPO stock may liquidate their positions, a no-sell period is often enforced to prevent immediate selloffs. During this period the price of the stock may decline, resulting in a loss. And again, business and market conditions may change during this period to the detriment of the stock price. (Ownership plays a key role when companies go public. Find out how, in IPO Lock-Ups Stop Insider Selling.)

Conclusion
From a distance, an IPO may look like a beautiful means of making money. Close-up, the many flaws become apparent. These should not dissuade a company from going public, however. Providing all the pros and cons have been understood and evaluated, and all the inherent risks assessed, if circumstances are right, an IPO may open profitable new opportunities for a company ready to be publicly traded.

But an IPO is not a guaranteed money maker for companies and/or shareholders. Some firms have been greatly disappointed by the price performance of IPOs. Finally, for companies that are currently being publicly traded, the opposite initiative – taking a public company private – may eventually prove more profitable than an IPO.

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