Going public refers to a private company's initial public offering (IPO), thus becoming a publicly traded and owned entity. Businesses usually go public to raise capital in hopes of expanding. Venture capitalists may use IPOs as an exit strategy (a way of getting out of their investment in a company).
The IPO process begins with contacting an investment bank and making certain decisions, such as the number and price of the shares that will be issued. Investment banks take on the task of underwriting, or becoming owners of the shares and assuming legal responsibility for them. The goal of the underwriter is to sell the shares to the public for more than what was paid to the original owners of the company. Deals between investment banks and issuing companies can be valued at hundreds of millions of dollars, some even hitting $1 billion.
Going public does have positive and negative effects, which companies must consider. Here are a few of them:
- Advantages - Strengthens capital base, makes acquisitions easier, diversifies ownership, increases prestige.
- Disadvantages - Puts pressure on short-term growth, increases costs, imposes more restrictions on management and on trading, forces disclosure to the public, makes former business owners lose control of decision making.
The Pros And Cons Of A Company Going Public
For some entrepreneurs, taking a company public is the ultimate dream and mark of success (usually because there is a large payout). However, before an IPO can even be discussed, a company must meet requirements laid out by the underwriters. Here are some factors that may qualify a company for an IPO:
- The company has predicable and consistent revenue. Public markets do not like it when a company misses earnings or has trouble predicting what they will be. The business needs to be mature enough that it can reliably predict the next quarter and the next year's expected earnings.
- There is extra cash to fund the IPO process. It is not cheap to go public, and funds from going public can't necessarily be used to pay for those costs as there are many expenses that start occurring long before it actually becomes public.
- There is still plenty of growth potential in the business sector. The market does not want to invest in a company with no growth prospects; it wants a company with reliable earnings today but one that also has lots of proven room to grow in the future. (For related reading, see: How an IPO Is Valued.)
- The company should be one of the top players in the industry. When investors are looking at buying in, they will compare it to the other companies in the space. If it's just average compared to competitors, investors won't pay as much.
- There should be a strong management team in place. The quality of leadership is one of the biggest factors investors look at outside of the financials. Additionally, many of C-level executives will have to talk on earnings calls, so they should be prepared and able to manage that aspect too.
- Audited financials are a requirement for public companies.
- There should be strong business processes in place. This one is valuable even if a company stays private, but going public means each aspect of how the company is run will be critiqued.
- The debt/equity ratio should be low. This ratio can be one of the biggest factors in derailing a successful IPO. With a highly leveraged company, it is hard to get a good initial price for the stock and the company may encounter stock sales problems.
- The company has a long-term business plan with financials spelled out for the next three to five years to help the market see that the company knows where it's going. (For related reading, see: Investing in IPO ETFs.)
Some underwriters require revenues of $10-$20 million per year with profits around $1 million. Not only that, but management teams should show future growth rates of about 25% per year in a five- to seven-year span. While there are exceptions to the requirements, there is no doubt how much hard work entrepreneurs must put in before they collect the big rewards of an IPO. (To learn more, see: IPO Basics.)