Businesses have a variety of options for raising capital and attracting investors. Generally, the two most common options are debt and equity – each of which can be structured in various ways. Equity allows a company to give investors a share of the business for which they earn returns as the business grows.
Both public and private equity have advantages and disadvantages for companies and investors. Equity, in general, is usually not a top priority for businesses when insolvency occurs but equity investors are typically compensated for this extra risk by higher returns. Companies of all types account for equity on their balance sheet in the shareholder’s equity category. As such, balance sheet equity is a driver of a firm’s net worth which is calculated by subtracting liabilities from assets.
Most companies start out as private but a public company can also sellout its public shares and go private if it finds the benefits to be greater. One of the biggest differences in private versus public equity is that private equity investors are generally paid through distributions rather than stock accumulation. Private equity investors usually receive distributions throughout the life of their investment.
Distribution expectations and other structuring details are discussed in a private placement memorandum (PPM) which is similar to a prospectus for public companies. The PPM provides all of the details for an investor. It also explains the requirements for investors. Since private placements are less regulated than a public investment they usually come with higher risks and therefore are generally geared toward more sophisticated investors. Usually, these investors will be labeled as accredited investors. Accredited investors are defined by investment regulations with a specified net worth. Accredited investors can be individuals as well as institutions such as banks and pension funds.
From the perspective of a nascent company, private equity often means having to please a smaller clientele. It also means fewer restrictions and investment guidelines from regulators including the Securities and Exchange Commission.
The offering of a private placement will generally be very similar to an initial public offering. Private companies often work with investment banks to structure the offering. Investment bankers help with structuring the value of private shares or paid in capital as is utilized in the offering. Investment bankers can also help companies test the investment demand and set an investment date. Unlike public investments, private companies may also solicit commitments over time from investors that help with long-term planning.
All companies need capital to run their business and the offering of private equity helps companies grow. Often, a private equity deal is done with the intention of the company someday going public. However, starting out as a private company gives management latitude to make distributions and manage equity at their discretion. It also allows them to avoid certain reporting and regulatory requirements, including those included in the Sarbanes-Oxley anti-fraud law.
Sarbanes-Oxley was passed in 2002 following the corporate scandals of Enron and Worldcom. It significantly tightened regulations on all publicly held companies and their management teams, holding senior managers more personally responsible for the accuracy of their companies’ financial statements. It also includes lengthy mandates for internal control reporting.
Overall, private equity isn’t subject to the requirements of Sarbanes-Oxley or the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, which means less burden for management. When Dell went private in 2013, after a quarter-century as a public company, Founder and CEO Michael Dell borrowed money and enlisted a leveraged buyout specialist named Silver Lake Partners to facilitate the deal. Never again does Dell have to please an impatient shareholder group by offering a dividend, nor will the newly private company ever need to repurchase its own stock and thus affect its price in the open market.
Most investors are more aware of public equity offerings. Generally, public equity investments are usually safer than private equity. They are also more readily available for all types of investors. Another advantage for public equity is its liquidity as most publicly traded stocks are available and easily traded daily through public market exchanges.
Transitioning from a private to a public company or vice versa is complex and involves multiple steps. A company that would like to offer their shares publicly will usually solicit the support of an investment bank. Most companies typically entertain the idea of a public offering when their value reaches a billion dollars, also known as unicorn status.
In an IPO deal, the investment bank serves as the underwriter and is somewhat like a wholesaler. Similar to private equity capital raising, the investment bank helps to market the offering and is also the lead entity involved with pricing the offering. Overall, the underwriter sets the price of the stock and then takes the majority of the responsibility for documenting, filing and finally issuing the offering to investors on a public exchange. The underwriter usually also takes some interest in the offering with a specified number of shares bought at the offering and subsequently when certain thresholds are met.
Comprehensively, the mechanisms for garnering public equity are easily understood and easy to execute. Every one of the thousands of publicly traded companies have gone through the IPO process at one point giving investors the opportunity to take part in these investments. As such, public equity is an investment that most all investors are familiar with. In addition to trading individually in the form of stock shares, it is also used in mutual funds, exchange-traded funds, 401(k)s, IRAs and a variety of other investment vehicles. Specifically, there are also several funds which focus on IPOs in their portfolios and IPOs individually can be some of the market’s top gainers.
The Bottom Line
All types of companies use equity to obtain capital and help their business grow. Both private and public companies can structure equity offerings in a few different ways giving investors different returns and voting options. Generally, public equity is widely known and highly liquid making it a viable option for most all types of investors. Private equity investing is generally geared more for sophisticated investors and often requires that investors are accredited with certain minimum requirements for net worth.
Accredited investors exploring a variety of investment options may be interested in following the returns of the private equity market versus the public market. The leading U.S. market gauges can provide one starting point through the Dow Jones Industrial Average, S&P 500 index and Nasdaq Composite index. To understand the returns of the private equity market for comparison, investors will have to dig a little deeper with monthly or quarterly industry reports from companies such as Bain Capital, BCG, and Private Equity Wire. As with all investments, understanding the risk-return tradeoffs and seeking the advice of a financial advisor can be important.